A derivative is a financial contract whose value depends on the price of an underlying asset, like a stock, ETF or index. Instead of owning the stock, you trade based on how you think its price will move. Think of it like betting on whether a stock will go up or down, without actually buying the stock itself. Derivates help investors to manage risk, invest wisely and earn profits from price changes.
Types of Derivatives
There are four main types of derivatives in the stock market. Here’s a simple explanation of each:
Futures Contract.
A futures contract is an agreement to buy or sell an asset at a predetermined price on a specified future date. Both buyer and seller are obligated to follow the contract. Futures contracts allow investors to hedge against price fluctuations, track market movements, and leverage their positions. However, the obligation to buy or sell the underlying asset at the agreed price exposes them to market risk.
Options Contract.
Options contracts give you the right, but not the obligation, to buy or sell an asset at a set price before a certain date. There are two types:
- Call Option: Gives you the right to buy.
- Put Option: Gives you the right to sell. You pay a small fee (called a premium) for this right. If the price moves in your favor, you can make a profit.
Swaps Contracts.
Swaps contracts are agreements between two parties to exchange financial assets or cash flows based on predetermined terms. Common types of swaps include interest rate swaps and currency swaps. For example, in an interest rate swap, one person agrees to pay a fixed interest rate while receiving a floating rate from another person. These are mostly used by big institutions to manage financial risk.
Forwards Contracts
Forwards are like futures, but they are private agreements between two parties instead of being traded on an exchange. They are customizable, allowing each party to tailor the terms to their specific needs, but carry higher risk because there is no third-party guarantee. Unlike futures contracts, forwards contracts are traded over the counter and are not standardized.
How to trade in Derivatives market.
Trading in the derivatives market involves a few simple steps:
1. Open a Trading Account. To start, you need to open a trading and demat account with a broker who is registered with a stock exchange (like NSE or BSE in India). Make sure the broker offers access to the derivatives market. Once enabled you can place trades online or through your broker.
2. Understand the Basics. Before trading, learn how derivatives like futures and options work. Unlike stock market derivatives require a different approach. For example, instead of buying stocks expected to rise, you may need to sell contracts to benefit from price changes
3. Choose Your Derivative. Decide whether you want to trade in futures or options and select the stock or index you want to trade on. You can go long (buy) if you think prices will rise or short (sell) if you think prices will fall. Since you must pay a small amount for the contract, ensure it fits in your budget.
4. Execute Your Trade. Use your broker’s trading platform to place your buy or sell order.
5. Monitor and Exit. Track your trade regularly. You can exit before expiry by placing an opposite trade or let it expire. Profits or losses depend on how the market moves.
Advantages and Disadvantages of Derivative trading.
Advantages
- Low transaction cost: These contracts bring about low transaction costs, which are useful to every investor. Compared to other securities, like shares and debentures, the cost of trading is lower, so You need low capital to take positions in a derivative market, unlike the stock market.
- Leverage: You can control a large position with a smaller amount of money. This means higher potential returns with less capital.
- Hedging: Derivatives offer a mechanism for investors to protect themselves from volatile markets by allowing them to transfer risk exposures associated with price movements of an underlying asset. Through a hedge, an investor can reduce their overall risk by decreasing potential losses and increasing potential gains.
- Profit from Any Market: You can make money in both rising and falling markets by going long or short.
- Liquidity: Many derivatives (like index options and futures) are highly liquid, allowing easy entry and exit.
- Diversification: You can use derivatives to diversify your investment strategies and manage risk better.
Disadvantages
- High Risk: Leverage can amplify losses just as much as profits. You might lose more than your initial investment.
- Complexity: Derivatives can be difficult to understand, especially for beginners, due to terms like strike price, margin, and expiry.
- Time-Sensitive: Most derivatives have an expiry date, which means you need to be right not just about the direction but also the timing of the move.
- Requires Active Monitoring: Prices can change quickly, so constant attention is needed.
- Not Suitable for All: Due to high risk and complexity, derivative trading isn’t ideal for conservative or inexperienced investors.
Some examples of derivative trading.
From among the two classes of derivative products i.e. lock and option, lock products e.g., futures, forwards, or swaps bind both parties to the agreed terms of the contract. Whereas option products (e.g., stock options), offer the holder the right, but not the obligation, to buy or sell the stock / asset at a specific price on or before the option’s expiration date. Traders use futures to hedge their risk or speculate on the price of an underlying asset.
For example, say Company A on 06 Apr 2025, buys a futures contract for Seeds at a price of Rs 620 per ton which expires on 19 Dec 2025. The company does this because it needs the seeds in December for a project and is concerned that the price will rise. Buying a futures contract hedges the company’s risk because the seller is obligated to deliver at Rs 620 per ton once the contract expires. Assume the price rises to Rs 800 per ton by 19 Dec 2025. Company A can accept delivery of the seeds from the seller at Rs 620, and if it no longer needs the seeds, can also sell the contract before expiration and keep the profits.
In this example, both the futures buyer and seller hedge their risk. Company A needed the seeds and wanted to offset the risk from a price increase in the future, and the seller could be concerned about falling prices and wanted to eliminate the risk through a futures contract that fixed the price it would get in December. It is also possible that one or both of the parties were speculators with opposite opinion about the price of seeds in December. In which case, one would benefit from the contract, and one might not.
The profit or loss depends on the difference between the agreed-upon futures price and the actual price at the time of its execution.
Who can participate in Derivatives market
In the derivatives market, there are diverse participants, and much depends on the trading motives of each trader. Participants can be segregated into four categories i.e. hedgers seeking to mitigate risks, speculators seeking to cash on opportunity in exchange of taking on risk, arbitrageurs exploiting price discrepancies for profits and margin traders leveraging borrowed funds for amplified gains. Let’s look at the motives and risk profiles of these participants that trade in the derivatives market.
Hedgers
Hedgers are traders who protect themselves from price movements and hedge the price of their assets by undertaking an exact opposite trade in the derivatives market. Thus, they pass on their risk to those willing to bear it. They are so keen to rid themselves of the uncertainty associated with price movements that they may even be ready to do so at a predetermined cost.
For example, a trader possesses 500 shares of a company XYZ Ltd., and the price is hovering at around Rs. 210. The trader wants to sell these shares in three months but feels the cost may fall by then. He is not wanting to liquidate the investment today, as the stock may appreciate.
He would like to receive a minimum of Rs. 200 per share and if the price rises above Rs. 200, he would like to benefit by selling them at a higher price. With such a motive, the trader can purchase a derivative contract called an ‘option’ that incorporates all the above requirements by paying a small price.
This way, he reduces his losses and benefits whether the share price falls or not. Thus, the trader is hedging his risk and transferring it to someone willing to take it. A day trader uses the options derivative to take advantage of intra-day fluctuations in prices.
Speculators
As opposed to hedgers, Speculators, look for opportunities to take risk in the hope of making good returns. They are averse to risk or even embrace risk on the premise, that higher the risk, higher the return.
Let’s go back to our example, wherein the hedger was keen to sell the 500 shares of company XYZ Ltd. but feared that the price would fall. In the derivative market, a speculator would expect that share price to rise. Accordingly, he will agree stating that he will buy shares at Rs. 200, even if the price falls below that amount. In return for giving that relief from this risk, he wants to be paid a small compensation. This way, he earns the compensation even if the price does not fall and you continue holding your stock.
Margin traders
Trading by use of the unique derivatives market mechanism is called margin trading. In margin trading the trader is not required to pay the total value his position but instead, only deposit a fraction of the total sum called margin. Hence with a small deposit, a trader can maintain a large outstanding position. This way a speculator can buy three to five times the quantity that his capital investment would have otherwise allowed him to buy in the cash market. During settlement when concluding the trade, the speculator either pays the outstanding position or carries out an opposing trade to nullify the outstanding amount.
For example, let’s say a sum of Rs. 1.0 lakh fetches 200 shares of XYZ Ltd. in the cash market at Rs. 500 per share. Suppose margin trading in the derivatives market allows purchase of shares with a margin of 30% of the value of the outstanding position. Then, you can buy 600 shares of the same company at the same price with your capital of Rs. 1.0 lakh, even though your total position is Rs. 3 lakhs.
If the share price rises by Rs. 50, the 200 shares in the cash market will deliver a profit of Rs. 10,000, which would mean a return of 10% on investment. However, in the derivatives market the same rise of Rs. 50 would fetch Rs. 30,000, which translates into a whopping return of over 30% on the investment of Rs. 1.0 lakh. This is how a margin trader, benefits from trading in the derivative markets.
Arbitrageurs
Arbitrageurs exploit imperfections and inefficiencies of the stock market to their advantage. Arbitrage is a low-risk trade where simultaneous purchase of stock/securities is done in one market, and a corresponding sale is carried out in another if the same stock is quoted at different prices in two markets.
In the earlier example, suppose the cash market price is Rs. 500 per share but is quoting at Rs. 510 in the futures market. An arbitrageur would purchase 100 shares at Rs. 500 in the cash market and simultaneously sell 100 shares at Rs. 510 per share in the futures market, thereby making a profit of Rs. 10 per share.
Trading as hedgers, speculators, margin traders, or arbitrageurs provides for increased liquidity in Capital Markets and thus contribute to their overall efficiency.
Conclusion
A derivative is a contract between two or more parties that is based on an underlying financial asset (or set of assets). Derivatives are used by traders to speculate on the future price movements of an underlying asset, without having to purchase the actual asset itself, in the hope of booking a profit. There is a wide variety of assets that are used to form the basis of derivatives trading, allowing traders to take positions on shares, bonds, indices, commodities, currencies and interest rates. Importantly, derivatives allow traders to take both long and short positions on an asset such as a stock, letting them bet whether a share price will rise or fall in the future. For traders, derivatives play a vital role in the financial system by acting as a form of insurance through the hedging process, allowing them to avoid negative price movements and mitigate losses, regardless of which way prices move. Derivatives have become popular because they are based on the monetary value of an asset rather than the tangible asset itself, allowing traders to trade without having to buy them. Derivatives also allow traders to utilize leverage, allowing them to take a much more sizable position compared to the amount of capital they can deploy, thus maximizing their potential for profits.
