TRADING STRATEGIES FOR DERIVATIVES MARKET
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1 TRADING STRATEGIES FOR DERIVATIVES MARKET 1
2 AGENDA Definition of Derivatives Origin of Derivatives Basic types of Derivatives Benefits of Trading Derivatives Trading Strategies 2
3 Definition of Derivatives 3
4 Definition of Derivatives Derivatives are financial instruments which are derived from some underlying commodity or asset. Derivatives are financial contracts that are designed to create market price exposure to changes in an underlying asset or event (eg. Forward contracts) they do not involve the exchange or transfer of principal or title their purpose is to capture, in the form of price changes, some underlying price change or event Derivatives have been responsible for the creation of trillions of dollars of wealth and also equally responsible for destroying large capital. The key therefore lies in judicious use of these instruments and consider them as Hedge Instruments rather than Trading products. 4
5 Origin of Derivatives The first known instance of derivatives trading dates to 2000 B.C. when merchants, in what is now called Bahrain Island in the Arab Gulf, made consignment transactions for goods to be sold in India. Derivatives trading, dating back to the same era, also occurred in Mesopotamia (Swan, 1993). A more literary reference comes around 400 BC from Aristotle tl who discussed a case of market manipulation. Aristotle's in his book Politics. tells the story of Thales, a poor philosopher from Miletus who made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. 5
6 Basic types of Derivatives Forward Contract is a customized contract between two parties to buy or sell a specified amount of currency/commodity at a specified price for a specific future date. Advantage Simple, liquid and requires no outlay of funds upfront. Disadvantage No participation in market volatility Profit and loss only crystallized on due date Importer: Opportunity profit unlimited / opportunity loss limited (Exporter: Vice-Versa) Example : X sells EUR 565,000 against MUR for value 31 st August 2011 at
7 Basic types of Derivatives A futures contract is an exchange traded, standardized contract that represents an agreement to buy or sell a quantity of asset/currency at a fixed price on a predetermined delivery date. One of the parties to the contract is the Exchange. Futures are suitable for companies that require commodities or near commodities traded on exchange at a predetermined fixed price. The exchange plays the role of mediating party, lowering the risk of defaulting significantly. Futures lock the buyer to a fixed price with potential loss of opportunity to save if the market prices fall. 7
8 Basic types of Derivatives GBOT ( Global Board of Trade ) set up in Mauritius offers the following derivative products currently Currency Pairs : EUR/USD, GBP/USD, Commodity Futures : Gold, WTI Crude Oil 8
9 Basic types of Derivatives An option buyer has the right but not the obligation to buy or sell a specific asset, at a specific price, at a certain future date and time The buyer of the option pays a premium to the option writer to induce him to accept the risk associated with the contract. It can also be Z buys a EUR Put / JPY Call strike for 2 weeks 9
10 Basic types of Derivatives Swaps: Swaps are an arrangement between two parties to exchange flows in the future according to a prearranged formula. The two commonly used swaps are: Interest rate swaps relates to interest related cash flows Currency swaps relates to both the principal and interest related cash flows with multiple currencies To convert an investment (asset) from: a fixed rate to floating rate. a floating rate to fixed rate. To convert an investment (asset) from: a fixed rate to floating rate. a floating rate to fixed rate. 10
11 Basic types of Derivatives A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to pay floating. By entering into an interest rate swap, the net result is that each party can 'swap' their existing obligation for their desired obligation To convert an investment (asset) from: a fixed rate to floating rate. a floating rate to fixed rate. To convert an investment (asset) from: a fixed rate to floating rate. a floating rate to fixed rate. 11
12 Futures vs Forward Contracts Features Futures Forwards Size of Contract Standardized Tailored to Individual Needs Maturity 3rd Wednesday of March, June, September & December Tailored to Individual Needs Transaction Mode Trading on exchange through Bank or Broker Telephone Commissions None; spread between Bid and Ask rates Brokerage or Bank Charge Security Initial Margin & Margin Calls Credit Line Regulation Exchange Supervisory Banking Act Delivery Generallyreversed reversed before maturity. Few GenerallyActualDelivery Delivery. Few Delivery Reversed 12
13 Benefits of Trading Derivatives 13
14 Benefits of Trading Derivatives Price Discovery o Futures market prices depend on a continuous flow of information from around the world o Require high degree of transparency o Broad range of factors impact supply and demand o This kind of information and the way people absorb b it constantly changes the price of an underlying asset. o Underlying assets can be geographically dispersed o Price of all futures contracts serve as prices that can be accepted by those who trade the contracts in lieu of facing the risk of uncertain future prices 14
15 Benefits of Trading Derivatives Risk Management o This could be the most important purpose of the derivatives market. o Centralized counter party reduces default risk o It is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. o Mauritian Exporters are exposed to vagaries of Exchange rate fluctuations. Seen a range of 45 to 38 over the last few years. o Imports getting costlier with USD appreciating over the years particularly hitting a high of 34/35 in 2010, with a range of 25 to 35 in the last 5 years. o No correlation in the adjustment t of EUR/MUR prices from the majors prices. 15
16 USD / MUR LAST 5 YEARS 16
17 EUR / MUR LAST 5 YEARS 17
18 EUR / MUR LAST 5 YEARS 18
19 EUR / MUR USD/MUR 19
20 Benefits of Trading Derivatives Market Efficiency o Brings all market players together o Transparency helps improve the spreads. o Those companies, Banks who find it difficult to get a counterparty, get a centralized counterpart for price efficiency and settlement efficiency o Reduces market transaction costs 20
21 Benefits of Trading Derivatives CERTAINITY TO BUSINESS COSTS Determine business exposure to market movements Estimate potential impact on profitability if exposure is left unhedged Identify hedging strategy No Hedge/Full Hedge/Partial Hedge Identify hedging instruments Recognize if the instrument accurately tracks the exposure Estimate potential gains and losses from the hedge Get management buy-in especially on the losses if hedge does not work 21
22 Trading Strategies 22
23 Trading Strategies Plan your Trades. You must devote time to study your chosen market, decide whether the prevailing trend is up or down, what timescale this trend is over and where the points of support and resistance are. Youhavetoplanwhereyouaregoingtobuyorsell,whereto place your stop loss and most importantly where to exit the trade. Once the trade is planned and executed, you must show discipline you made the trade for a good reason with solid justification, so any changes need equally solid justification. Don t let your Losses Run and Closing Winners Too Early Avoid Chasing Losses by compounding Don t overtrade : Traders get addicted to the thrill of markets and take positions without planning, just to be playing in the market. 23
24 Trading Strategies Overtrading Everyone loves the thrill of placing a trade and entering the market many traders tend to overtrade, placing too many trades that t haven t been planned properly just to be in the game and part of the action. Staking Too Much Money management is the key to real success too many traders risk far too much of their trading pot on each trade, looking for the big win rather than gradual and controlled growth through smaller more manageable trades. If you go seeking the big win, more often than not you will end up finding the big loss and then its game over. 24
25 Trading Strategies Do not buy / sell all of your required quantity at a time. Buy in certain units. If you desire to buy 500 units, buy/sell 100 at a time so that you can have fund to buy if the shares are available at better rates. Do not buy when the whole world is talking about bulliah markets. J.F.Kenedy once said that when the shoe shine boy on the street corner says to buy, it is time to sell. An intense Trader would prefer to buy when there is Blood in the Market Do not square off at a very low profit. Try to earn substantial profit. This strategy will help you when you are about to make a substantial loss. Do not do the next transaction in the same item at a very narrow interval of profit. Try to get at least 5 % gain. 25
26 GBP/USD LAST 5 YEARS 26
27 GOLD LAST 5 YEARS 27
28 CRUDE OIL LAST 5 YEARS 28
29 UNDERSTANDING FOREX MARKETS This $3.21 trillion in main foreign exchange market turnover per day Spot: 1.05b Forwards: 0.400b Swaps: 1.8b [Derivatives contributed to 75% of the volumes] London :34%, New York :26%, Tokyo : 8% 29 Other centers made up for the remainder
30 MARKET PLAYERS Banks The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. Central Banks National central banks play an important role in the foreign exchange markets. Commercial Companies An important part of this market comes from the financial activitiesities of companies seeking foreign exchange to pay for goods or services. 30
31 MARKET PLAYERS CENTRAL BANKS - The mere expectation or rumour of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. 31
32 Trading Strategies 32
33 33
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