The derivatives market is a risky trading avenue. The higher leverage and attractive risk-return ratio offered by derivative instruments make them popular among traders looking for a solid profit. Investors can diversify their portfolios and improve risk management using derivative options and futures. Understanding derivatives trading is crucial if you want to trade equity, commodities, or currency.
The spot price in a derivative contract refers to the current market price of the underlying financial asset. In this blog, let's understand the meaning, definition, and importance of spot price.
The spot price in the derivative marketplace is the current price at which any given asset, such as a security commodity or currency, can be purchased or sold for immediate delivery. Generally, spot prices are determined based on time and place. In the global economy, the spot prices of common commodities or securities are fairly uniform with respect to exchange rates.
Technically, the spot price is the value that sellers and buyers assign to an asset right now. The uniformity of spot price ensures no arbitrage opportunities in the derivatives market, which could result in significant price disparities in different markets.
The futures and forward contracts lock in the desired spot price of a commodity at a future date because the prices constantly change when the supply and demand fluctuate. Thus, the spot price plays a major role in determining the price of a future contract. It is an indicator of fluctuations in the pricing of future commodities.
The strike price corresponds to the price at which you can buy the underlying asset while exercising the call or put option. It is also called the exercise price. It is a predetermined price at which the options contract holder has the right to buy or sell the underlying asset. It is a fixed price agreed upon at the initiation of the options contract and remains constant throughout the lifespan until the options contract is exercised or expires.
The strike price is a reference point around which all options trading revolves. In the options chain, the prices are determined based on the strike price.
The future price is the price of the commodity mentioned in a futures contract specifying that the transaction will occur at a later date. Buyers of futures contracts lock in the price in advance. The future price is determined based on the current spot price and the cost of carry during the interim period before delivery.
As a futures contract involves a physical delivery, the cost of carry or the storage cost, including the interest, insurance, and other incidental expenses, must also be added to arrive at the future price.
Understanding the relationship between spot and future prices is crucial in the derivatives market. The spot price is for the immediate buying and selling of the underlying asset. In contrast, future price corresponds to delayed payment and delivery at the predetermined price on a future date.
Generally, the spot price will be below the future price. This is called a contango situation. If the spot price exceeds the future price, it is called backwardation. At some point during the interim period of the futures contract, the futures price and the spot price will converge.
When the future price loses its value and falls to meet the lower spot price, it favours short positions in a contango situation. On the other hand, backwardation favours a long position when the future price rises to meet the spot price.
The spot price and strike price are relevant in options trading. Their intrinsic linking significantly influences the value of an options contract. The relationship between the spot price and the strike price determines the option's moneyness. There are 3 different categories:
The relationship between an underlying asset's spot price and strike price determines the option premium. Intrinsic value is the difference between the spot price and strike price that can result in immediate profit when the option is exercised. The time value corresponds to the potential of the spot price to move in a favourable direction before the option expires.
The option time value increases when the spot price moves closer to the strike price as the option can become in the money (ITM). Similarly, the time value decreases as the spot price moves away from the strike price, making the option out of the money (OTM).
Let's consider ABC as our underlying asset.
If the spot price increases to Rs 2,700 before the expiry of the call option with a strike price of Rs 2,600, the call option holder can exercise the option to buy at Rs 2,600 and immediately sell them at the market price of Rs 2,700, making a profit.
If the spot price remains below Rs 2,550 until the expiry of the futures contract, the buyer of the futures contract might incur a loss as he would be obligated to buy the shares at Rs 2,550 when the market price is lower.
Trading in the derivatives market can be profitable for traders who understand the difference between the spot, strike, and future prices. All these terms describe the value of a financial instrument in a different time horizon based on market dynamics. Evaluating these prices before trading is crucial to succeeding in the futures and options (F&O) market.
To implement the various trading strategies, understanding the interplay between commodity pricing is necessary to achieve your investment objectives.