Getting to know derivative trading as the stock market gets ready to embrace it.
By 2025, the Bangladesh Securities and Exchange Commission (BSEC) will introduce derivatives products in the stock market. The announcement came from BSEC during a workshop titled ‘Financial Derivatives of Exchange Traded Platform-M,’ organised by the Dhaka Stock Exchange (DSE).
The BSEC hopes to introduce derivative products by 2025 to keep up with the expected changes in the economy. In the interim, the Central Counterparty Bangladesh Limited (CCBL) is expected to begin operations. Merchant banks, asset management firms, CDBL, CCBL, and the Bangladesh Securities and Exchange Commission (BSEC) were attendees of the event.
WHAT ARE DERIVATIVE PRODUCTS?
In the fast-paced world of the stock market, derivative products act like financial shadows, mimicking the price movements of stocks but offering a unique set of tools for investors. Unlike directly buying stock, which makes you a shareholder in the company, derivatives are contracts whose values are derived from the values of underlying assets, such as a particular stock or stock index. These contracts come in various forms, each catering to different investment goals. Futures contracts, for example, lock in a price for a stock today, for delivery at a later date. This can be a boon for investors who want to protect themselves from future price swings.
WHY INVEST IN DERIVATIVES
While there are several reasons why an investor might choose derivatives over directly buying stocks, they can be broadly categorised into three main goals: hedging risk, speculating on stock prices, and generating income.
Hedging Risk
Imagine you own a portfolio of stocks and are worried about a potential market downturn. Derivatives, particularly, ‘put options’, can act as a protective shield. By buying put options on the stocks you hold, you gain the right to sell those stocks at a predetermined price by a certain date. Even if the stock price falls, you can still exercise your option and sell your shares at the agreed-upon price, limiting your losses. This hedging strategy allows you to participate in the potential upside of the stock market while mitigating the downsides.
Speculating on Stock Prices
Unlike directly buying stock, which makes you a shareholder in the company, derivatives allow for speculation on the future direction of stock prices without actually owning the underlying equity. This can be particularly appealing for investors who have a strong conviction about the stock’s future movement. For example, if you believe a particular lot is undervalued and poised for significant growth, you could buy ‘call options’. Call options grant you the right to buy the stock at a certain price by a certain time, even if you are under no obligation to do so. If your prediction is correct, and the stock price rises, you can exercise your call option and purchase the stock at a lower price, locking in a profit.
Generating Income
This might be a surprising use of derivatives, but some option contracts can be used to generate income. This strategy involves ‘option writing’, where you sell an option contract to another investor and collect a premium in return. The premium you receive represents income, but it comes with the obligation to fulfil the terms of the contract if the other party exercises their right to buy or sell the underlying stock. This strategy can be especially useful for investors who are looking for additional income from their portfolio, but it does require careful consideration of the risks involved, as you could be obligated to buy or sell stock at an unfavourable price.
DO DERIVATIVES CARRY RISK?
Derivative products offer unique advantages in the stock market, but also come with a distinct set of risks that investors should be aware of before diving in. These risks include the inherent leverage of derivatives, which can magnify both profits and losses based on stock price movements. Their complex nature requires a strong financial understanding to avoid misunderstandings that could lead to poor investment decisions.
Unlike buying stocks directly, derivatives involve counterparty risks, meaning that the other party to the contract could default on their obligations, especially in less regulated over-the-counter (OTC) markets. Additionally, liquidity risks exist where derivatives contracts – specifically complex ones or those with lower trading volume – may be difficult to buy or sell quickly, potentially leaving you stuck in an unfavourable position.
Finally, ‘margin trading’, common with derivatives like futures contracts, carries the risk of margin calls. These calls require you to deposit additional funds if the market moves against you and the value of your contract declines. If you can’t meet the margin call, your broker may be forced to sell your position at a significant loss.
With all its advantages and disadvantages, the Bangladesh Securities and Exchange Commission’s (BSEC) planned introduction of derivative products by 2025 presents an exciting opportunity for the country’s financial markets. These instruments provide investors with a broader array of tools for managing risks, speculating on stock prices, and potentially generating income.
However, the BSEC must implement robust regulations and investor education initiatives to mitigate the inherent hazards associated with derivatives. By fostering a well-informed and secure derivatives market, the BSEC can empower Bangladeshi investors to engage in a more dynamic and globally integrated financial landscape.
