Instruments traded in the stock markets Part IV - Stock Market FAQs

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Instruments traded in the stock markets Part IV

 

• What is an Overvalued Stock or an Undervalued Stock?

An overvalued stock can be understood as an inflated hope that a company will do well. Thus, a stock is overvalued if its current price exceeds the intrinsic value of the stock. The market may temporarily price stocks too high or too low and that's how investors determine whether stocks are being overvalued or undervalued. If a stock is overvalued, the current price of the stock exceeds its earnings ratio (PE ratio*) and hence investors expect the price of the stock to drop. A high PE(profit earning) in relation to the past PE ratio of the same stock may indicate an overvalued condition, or a high PE in relation to peer stocks may also indicate an overvalued stock.

Thus the PE ratio is one of the many ways to determine whether a stock is overvalued. A company's P/E ratio is computed by dividing the current market price of one share of a company's stock by that company's per-share earnings.

Eg: P/E ratio of 10 means that the company has Rs1 of annual, per-share earnings for every Rs10 in share price

A stock is undervalued when, if is selling at a much lower price than what it is actually worth. This can be determined based on fundamentals like earnings and growth prospects. One of the best-known measures for finding an undervalued stock is the price earnings ratio (P/E).

Consider Reliance and Airtel, which are in the same industry and have similar fundamentals. If Reliance has a P/E of 15 and Airtel’s is 20, Reliance could be an undervalued stock.

• What are Derivatives?

A derivative is a financial instrument whose value depends on the values of other underlying variables. As the name suggests it derives its value from an underlying asset. For Ex-a derivative, may be created for a share, or any material object. The most common underlying assets include stocks, bonds, commodities etc.

The different types of Derivatives?
Derivatives are basically classified into the following:

1. Futures /Forwards
2. Options 
3. Swaps 

• What are Futures?

A futures contract is a type of derivative instrument, or financial contract where two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price.

• What are Index Futures?

Index futures are futures contracts where the underlying is a stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

• What are the uses of Derivatives? What are the various derivative strategies that I can use?

Derivatives have a multitude of uses namely:

a) Hedging:-

A hedge is used to reduce any substantial losses/gains suffered by an individual or an organization.

b) Speculation:-

Speculation is the practice of engaging in risky financial transactions in an attempt to profit from short or medium term fluctuations in the market value .

c) Arbitrage:-Arbitrage is the practice of taking advantage of a price difference between two or more markets.

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