Are you looking for some investment vehicles that can help you gain maximum return at a low cost? If so, then derivatives can be something to opt for. While at the beginning of one’s investment journey, investing in derivatives can be a risky affair.
However, as you gain experience in the market, you can opt for trading derivatives. This article will help you understand what is derivative and derivatives trading in India.
What is Derivative?
So, to begin with, let’s find out what is derivative. So, derivatives refer to financial contracts whose value depends on the underlying asset. These assets can be anything from stocks to commodities, currencies, or other financial instruments.
This contract is formed between two or more parties where one party anticipates the value of the underlying to go up, and the other party assumes the value to go down, and they bet on the anticipation.
In India, derivatives trading takes place on stock exchanges as well as over the counter. However, the risk in over-the-counter derivatives trading is way too high, as there are no regulations to hold the counterparty responsible if they do not abide by the contract.
If you want to trade derivatives, you can trade them on stock exchanges like NSE, BSE, and others to minimize the default risk.
As the name signifies, derivatives meaning is nothing but something that derives its value from another asset or something else. The derivatives derive their value from the price of the underlying asset or the fluctuation in their prices.
For instance, if you buy a call option of gold, the premium for the options contract, which is a derivative contract, will depend on the price of the gold at that moment, and the chances of it becoming profitable, so the price fluctuates. So, to trade derivatives, you need to understand and study the underlying asset’s price movement.
Another example could be stock, and you all know that stock prices fluctuate frequently. Derivatives help you earn by correctly predicting whether the stock prices will go up or down.
So, if your prediction is right, you can earn, and if it goes wrong, you can lose money too. Derivatives help you gain from the price fluctuation of the assets without directly investing in the asset.
This is the most important thing to note while studying and trading derivatives. So, if you are predicting the price of the stock to go up or down, you do not buy the stock itself. You buy a futures contract or call option.
In case the price goes up, you can execute the derivative contract to claim your profit. That takes us to the next segment of the article, which is the types of derivatives.
Types of Derivatives
In the stock market, you can find four different types of derivatives. They are –
- Forward Contacts: Forward contracts are part of derivative trading where two parties agree to buy and sell their asset on a future date they both agreed upon and at a predetermined price. So, the date of buying and selling the asset gets fixed as well as the price for the trade at the time of making the contract.
However, these forward contracts are highly customized as they are traded over the counter. Thus, they carry high default risk as well. These are self-regulated and from price to the expiry date, everything is decided by the two parties themselves. Here, both parties have the obligation to buy and sell the asset they have agreed upon. However, due to OTC trading, there remains a high chance of any party defaulting.
- Future Contracts: Future contracts are just like forward contracts that are traded on the stock exchanges. In future contracts, like in a forward contract, there is a predetermined price of trading the asset on a future date that is also the expiry date of the contract. However, since these derivative contracts are traded on the stock exchanges, the parties who enter the contract do not meet and prepare their agreement.
The futures contracts are standardized contracts unlike forward contracts, which are customized. Thus, the risk of defaulting is lesser in future contracts than in forward contracts. The obligation remains the same as in the case of the forward contract upon expiry. Both the parties have to trade the underlying asset as per the terms in the contract.
- Options: The most popular and also tricky derivative is the options. Options are also financial contracts/ derivative contracts where the buyer of the option contract gets the right but not the obligation to buy or sell the underlying asset at predetermined prices and on or before a specified date. There are two types of options contracts –
- Call option: This is an option contract where the buyer of the contract gets the right to buy the underlying asset at a predetermined price on or before a specified date/ expiry date but has no obligation to do the same if their desired price is not achieved.
For instance, you bought a call option with a strike price of Rs. 1000 and the underlying asset is the Stock of ABC company, which is currently trading at Rs. 990 and you think the price will go up the next month.
Let's assume the expiry of the contract is after a month, and on the date of expiry, the stock ABC is trading at Rs. 1500. You can execute the contract and buy the shares at Rs. 1000 as you purchased the call option earlier. Now, if the price had gone down to Rs. 700, then on expiry, there is no need to execute the option. It will automatically be invalid as there is no obligation to fulfil the contract, unlike forward or futures contracts.
- Put option: If you think the price of an asset will go down, you can buy the put option, which is a derivative contract as well. These contracts give you the right to sell the underlying asset at a predetermined price on or before a specified date. Just like the call option, put option buyers have the choice but no obligation.
- Swap Contracts: Swap contracts are one of the most intriguing derivative contracts available in the stock market among all other derivative contracts. These contracts are generated privately between both parties. So, these are customized contracts, and they agree to exchange their cash flows based on a predetermined formula. The underlying asset in swap contracts is interest rates or currencies.
Participant of derivatives
The derivatives market is quite lucrative. Here, you can earn unlimited profits without taking exponential risks and, thus, there are multiple participants in Derivatives Market.
- Hedgers: Firstly, some hedgers use derivative contracts to hedge different risks prevailing in the stock market. Hedgers in the derivative market are mainly producers and manufacturers of different agri-items and other manufactured products. They hedge the risk of falling prices of their products by buying future or forward contracts.
For instance, there is a farmer who produces rice. He thinks the price will drop drastically in the next three months. He buys future contracts with a strike price of Rs. 100/kg. Now, on the expiry of the contract, the price of rice falls to Rs. 80/kg, However, the farmer can still sell the future contract’s underlying asset – price at Rs. 100/kg.
- Margin traders: In the derivative market, you will also find the margin traders who are day traders and their earnings depend upon the market movement within a day. These margin traders borrow the money from the stockbrokers and then trade on the same and return.
- Speculators: The third market participants are the speculators who predict the prices and buy derivatives accordingly. If their guesswork matches the reality, they make profits.
- Arbitrageurs: These are traders who buy securities in one market/ exchange and sell them on the other and p\make profit from the gap or difference in the prices.
Benefits of Derivatives
The benefits of derivatives are uncountable and here are some of the crucial ones –
- Reduce market volatility: Derivatives trading can help you reduce the risk possessed by market volatility. For instance, if you want to mitigate the risk of your stock investment, you can buy a put option to protect yourself from the downside risk of the investment.
- Best for hedging: Derivatives and hedging go hand-in-hand. Derivative contracts are best for hedging yourself from any bad investment decisions. As no one can fully predict the market, and there can be many discrepancies, derivative contracts can easily minimize your risks.
- Helps you roll your excess funds: While derivatives are best for hedging and risk-minimizing, it is also great for investing your surplus income at a place that can give you constant returns.
Investing in derivatives is risky, but it can also be profitable. You can gain huge returns if you can rightly predict the price movement of the underlying asset. Though these are a bit more complex than equities or debt instruments, they are more intriguing and return-generating investment avenues.