Benefits of Derivatives

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You can do derivatives trading in India via NSE and BSE in stocks. Just like this, you can trade in commodities; MCX and NCDEX are there. However, if you want to trade in currency, you can do it through NSE-SX or MCX-SX.

In this article, we will focus on derivatives trading and its know-how.

Derivatives Meaning:

Derivatives in stock market are financial contracts whose value depends on the underlying asset or group of assets. The commonly used assets include stocks, bonds, currencies, commodities, and market indices.

The underlying asset's value keeps fluctuating according to market conditions. The primary principle behind entering into derivative contracts is to earn profits by speculating on the value of underlying assets in the future.

For instance, imagine an equity shares market price going up or down, and you may suffer a loss due to the fall in the stock value. In this situation, you may go for derivatives trading and enter a derivative contract either to make a profit or just to cushion yourself from the losses in the spot market.

You can find more information on the meaning of Derivatives in our previous article “Meaning of Derivatives.”

What are the Benefits of Derivatives Trading?

Derivatives offer numerous advantages to the financial markets. Let's look at the benefits of derivatives:

Exposure to Hedging Risk

Since the value of the derivatives is directly linked to the underlying asset's value, the contracts are mainly used for hedging risks. For instance, an investor may buy a derivative contract whose value moves opposite to the value of an asset the investor owns; this way, profits in the derivative contract may offset losses in the underlying asset.

Market Efficiency

Derivatives trading in India increases the efficiency of financial markets, and by using derivative contracts, one can easily replicate the payoff of the assets. Therefore, the underlying asset prices and the associated derivatives tend to be in equilibrium and help to avoid arbitrage opportunities.

Underlying Asset Price Determination

Derivatives determine the underlying asset price. For instance, the spot prices of the futures can serve as an approximation of a commodity price.

Access Unavailable Assets/Markets

With derivatives, organizations can have access to otherwise unavailable assets or markets. With the help of interest rate swaps, a company may obtain a more favourable interest rate instead of interest rates available for direct borrowing.

Types of Derivatives

Basically, there are various types of derivatives:

Futures and Forwards Contract

Futures are standardized contracts traded on the exchange, whereas a Forward contract is an agreement between two parties traded over the counter (OTC)

Futures do not carry any credit risk as the clearinghouse acts as a counterparty to both parties in the contract. To reduce the credit exposure further, all positions are marked-to-market daily, where all participants need to maintain margins all the time.

In contrast, forward contracts do not have such mechanisms in place as these are settled only at delivery time. The credit exposure keeps on increasing as profit or loss is realized only at the time of settlement.

Futures contracts are traded in the secondary market, where participants can easily buy or sell their contract to another party willing to buy it. Whereas forwards are unregulated; hence, there is no secondary market for them.

Options Contract:

In this type of derivative, the party has the right but not an obligation to buy/sell the underlying assets. The buyer pays the premium to buy the rights from the seller, who receives the premium along with an obligation to sell the underlying assets if the buyer exercises his rights.

One can trade options in both exchange-traded markets and the OTC market. Options can further be divided into two types - call and put.

Swaps

A swap is another form of the derivative contract made between two parties to exchange cash flows in the future. Currency swaps and interest rate swaps are the two most common and popular swap contracts traded over the counters between financial institutions.

All in all, futures and forwards together are the best hedging instruments used to speculate the price movement and make maximum profit.

Who are the Participants of the Derivatives Market?

Majorly there are four types of participants in the derivatives market:

Hedgers:
These investors enter the derivative market to reduce or hedge their risk. Hedging is the biggest motive that drives investors to the derivative market. The hedgers prefer the option route to reduce their risks.

Speculators:
Speculators bet against future price movements and take positions accordingly. It is risky and involves buying the underlying asset and then betting on its price. Speculative activities aim to earn big profits.

For example, an investor expects a share price to drop in the future. Thus, the investor will short-sell the share now and buy later when the price drops to profit from this.

Arbitrageurs:
Arbitrage is also a profit-making activity that leverages the price volatility in different financial markets. Arbitrageurs make a profit using the price difference resulting in investment between the two markets. It means buying an asset at a lower price in one market and selling it in another market.

Margin Traders:
Another participant in the derivative market is margin traders. The margin is the initial deposit that an investor makes when entering into a contract. The margin alloted can vary depending on various factors. Hence it is advised to use derivatives margin calculator to get the exact amount of margin required for a particular trade.

The Prerequisites for Trading in Derivative

For trading in derivatives, you are required to fulfil three key prerequisites:

Firstly, you must have an active Demat account.
Secondly, you must have a trading account in India. If you don't already have a trading account, you can connect with stockbroking firms like Choice India, which can help set up a free trading account in India for you. Once both your Demat and trading accounts are ready, you need to link both accounts.
Lastly, you must maintain a specific percentage of cash in your trading account to trade in derivatives. This specific percentage of cash is called margin money.