How to buy a car (at the best price) and Financial Instruments brushup
If you want to buy a car, you can achieve this in three ways:
- You go to a showroom, choose a car, make a payment and take the car home. You really need the car today, or don’t see a change in car prices in the near future
- Maybe you don’t have the money to pay for the car right now, but you really like the price of the car today. So you make a booking to buy the car after three months at a price that you and the dealer agree on today. On that specified date, the dealer will deliver the car to you and you will pay him the price that you agreed on.
- Now you don’t have the money and like today’s price but you also think there is a chance car prices may fall in the future. You ask the dealer if there is any chance he will let you buy the car in three months at a price that you and he agree on today, only if you want to. The dealer agrees, but wants an upfront lock-in price. You’re not obligated to buy the car, but he won’t return your payment if you choose not to buy.
On the delivery date, if predetermined price — current price > lock-in amount, you can simply choose to forgo your lock-in amount, and buy the car at current price.
Now let’s put this in the context of finance.
Financial Asset Classes
These are the assets that you can trade on the market, and they can be of different types:
- Equity/Stock — Represents ownership of an asset. If you buy 10 shares of AAPL, you now have ownership in the company and partake in company’s profit and losses
- Debt/Bond — Represents a loan made by the buyer of the bond to the seller/issuer. If you buy 3Y 7% Govt bonds, you make a loan to govt for 3 years and receive 7% interest
- Currency/Foreign Exchange — conversion of one currency into another currency
- Commodity — Gold, Silver, Oil, Agricultural Crops like wheat, corn etc
Each asset class can have multiple types of instruments — cash, futures, options
Market Index — What is S&P 500 or NIFTY?
Market Index is a mathematical construct, it is the aggregate value of a group of securities and used to represent and track a particular market.
- For example, the S&P 500 Index is the aggregate value of stocks of 500 largest companies (by market capitalization) in the US
- It is a proxy for performance of overall stock market in the US, and by extension, also a proxy for market sentiment on the state of US economy
- After Brexit in June’16, S&P 500 Index fell by 3.5%, reflecting negative investor sentiment, i.e the said event would adversely affect the US economy
- Traders also track changes in the index’s value over time and use it as a benchmark to compare performance of their own strategies
- Market Indices can also track a sector, for example a US tech sector index will only consist of stocks of tech companies in the US
Other Major Stock Indices: EuroStoxx50(Euro), Nikkei225(Japan), NIFTY50(India)
Financial Instruments
Financial Instruments can be
- Cash
- Futures
- Options
You can trade different types of instruments for each asset class.
Cash and Futures
Cash and Futures are two ways to exchange financial assets.
Cash — Exchange of assets happens right now at the current price of the asset. Also called a spot contract
Future — Exchange of assets happens at a specified time in the future at a set price which is decided today. The buyer of the futures contract is the person who will buy the asset. The buyer is long the future.
In our example with the car,
- Buying car on the spot was a cash contract
- Buying the car at a predetermined price on a future date was a futures contract
Why do we need futures contract?
- In our example, you fixed a price for the car by making a booking. You pay this price even if the car is more expensive on the date of delivery, reducing risk of a higher price
- Similarly, a corn farmer, may want to fix a selling price for his crop when it harvests in March and a company may want fixed buying price to determine where to price their corn products. The farmer and company can enter into a futures contract for delivery of grain from the farmer to the buyer in March. This trade allows the farmer and the company to fix a price that both believe will be the fair price in March. It is these contracts (and not actual grain) that are traded in the futures market
- Market Index futures are very popularly traded products. Since a Market Index is a mathematical construct, you cannot directly buy or sell an Index, but you can trade futures contract on the Index. The futures contract will be traded at the value you think will be the fair value of the Index on “delivery date”
Derivative Contracts
A futures contract is a derivative — its value derives from and is dependent on the value of an underlying asset, such as the car, corn or Market Index
Options are another type of derivative contract
- Options, like futures contract are an agreement that gives the buyer of the contract an opportunity to trade an asset with the seller of contract at a fixed price on a future date. Unlike futures, the buyer of an option contract does not have an obligation to make the transaction, the trade is “optional”
- Unlike futures, you have to pay a price to buy the optionality of an options contract
- In our car example, if you paid the dealer a lock-in price for the option of deciding if you want to buy the car or not, you entered into an options contract.
Calls and Puts
- Call option — A contract which gives the buyer of the contract the option to “buy” an asset from the seller of the contract at a fixed price on a future date
- Put option — A contract which gives the buyer of the contract the option to “sell” an asset to the seller of the contract at a fixed price on a future date
- In both cases, the buyer of the option contract will pay the seller an upfront amount or premium for the optionality. The buyer has to pay this premium irrespective of whether the buyer chooses to not exercise his right to trade or not
- The fixed price is called the strike price
- The fixed date is called the expiration date, the date on which the contract expires
In our car example, if you paid the dealer a lock-in amount for the optionality to buy the car at a fixed price on a future date, you bought a call option from the dealer.
Why Options?
Traders buy options for their optionality to trade — you have a right, but not an obligation to trade, and their limited downside. The maximum you can lose in an options trade is the premium that you pay upfront to buy the option
If AAPL is trading at 100$ and you think that the stock is going to rise. If you buy AAPL stock and you’re right, you make a profit. If you’re wrong, you can lose up to 100$.
Alternatively, you can buy a call option that gives you the right to buy later at 100$. If you’re right, you can buy those shares at 100$ and sell back in the market for a higher price. If you’re wrong and the stock price falls, you just choose to not exercise your option, only losing the premium that you would have paid upfront.
Similarly, let’s say you already own AAPL shares which you bought at 100$ and are worried that stock price may fall when they announce the new IPhone. You can buy a put option at 100$ which gives you the ability to sell your shares at 100$ should your stock unexpectedly plummet. If the price stays stable or rises, you take no action.
