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Derivatives are essentially contracts that derive their value from an underlying asset. Derivative contracts are short-term financial instruments that come with a fixed expiry date. The underlying asset can be stocks, commodities, currencies, indices, exchange rates, or even interest rates. Derivative trading involves both buying and selling of these financial contracts in the market. With derivatives, you can make profits by predicting the future price movement of the underlying asset.
Derivatives can be classified into the following types:
Futures contracts are standardised contracts to either purchase or sell an asset at an agreed-upon price at a specified future date. These contracts are listed on exchanges and are popular with traders and investors to hedge or speculate on price movements. Futures contracts are leveraged, which means a trader only puts up a margin and enables him or her to control a larger position with less capital. However, both sides are required to adhere to the contract by either accepting or executing delivery of the asset or by a cash settlement.
An option gives the buyer the right, but not the obligation, to purchase or sell an asset at the agreed price during some specific time period. There are two option types — call options (which provide the right to purchase) and put options (which provide the right to sell). The option has a premium that is the maximum potential loss to the buyer. If it doesn’t get exercised before the expiry date, the option becomes worthless. In contrast to futures, which obligate the buyer and seller to the transaction, options provide flexibility, as the buyer can let the option expire unexercised if it is not profitable.
It is similar to futures, wherein you agree to buy or sell an asset at a future date at a predetermined price. However, forwards are tailored and traded over-the-counter (OTC). They are privately negotiated between two parties, in contrast to futures. This provides much more flexibility but introduces counterparty risk since no exchange or clearing house guarantees the contract.
Swaps are agreements between two parties to exchange cash flows based on certain variables. The most common types of swaps are interest rate swaps, with one party exchanging fixed interest payments for floating ones (or vice versa), and currency swaps, with cash flows in one currency being exchanged for cash flows in another. Swaps can be customised to fit the respective needs and used to hedge risks.
There’s a key difference between a futures and an options contract. In the case of options, the buyer or the seller can either choose to exercise their right to buy or sell the underlying asset, or they could let the right lapse upon the expiry of the contract. With a futures contract, both the buyer and the seller are legally obligated to honour the contract upon expiry, and both parties must exercise the contract before expiry.
To get started with trading in derivatives, you are required to fulfil three key prerequisites:
Derivative trading requires you to keep a specific percentage of the value of your outstanding derivative position (total value of your holdings) as cash in your trading account. This specific percentage is commonly referred to as ‘margin money’. You are required to hold this margin money to help minimise the risk exposure for the stock exchanges you’re trading on. Furthermore, it works as a buffer to minimise losses for the stockbrokers who give you the remaining amount as a loan to buy the derivatives contract.
Whenever you execute a trade in a derivative contract, you’re required to pay certain charges and taxes. Some of these are listed below.
Since derivatives such as futures and options derive their value from underlying assets, they can drive the prices of those assets in the short term. For instance, when the number of people buying futures and call options with a particular stock as the underlying asset rises exponentially, it paints an optimistic view on the stock’s near-term price. This creates more demand and triggers investors to buy more shares of that stock in the cash segment, thereby increasing the stock prices.
The derivatives market consists of various participants, each playing a unique role based on their goals and risk appetite. These participants can be broadly classified into seven groups, and their involvement contributes to the overall liquidity and efficiency of the market.
Hedgers are the primary participants who use derivatives to mitigate risk. Their main goal is to protect against price fluctuations in the underlying asset. For example, farmers might use futures contracts to lock in a price for their crops before harvest, safeguarding their income against price drops. Businesses involved in international trade may also use currency derivatives to hedge against exchange rate risks. By using derivatives in this way, hedgers can ensure stability and reduce exposure to market volatility.
Speculators seek to profit from market movements. Unlike hedgers, speculators don’t own the underlying asset but trade derivatives based on predictions of price changes. They take higher risks by making bets on future price directions, such as purchasing options or futures contracts. Speculators play a vital role in adding liquidity to the market, which enables hedgers to execute their trades more easily.
Arbitrageurs exploit price discrepancies between related markets to make risk-free profits. If the price of an asset varies between two markets, arbitrageurs step in to buy low in one market and sell high in another, capitalising on the price difference. Their actions help correct market inefficiencies and align prices across various platforms, contributing to market efficiency.
Institutional investors, such as mutual funds, pension funds, and hedge funds, are among the largest participants in the derivatives market. They typically use derivatives for portfolio diversification, risk management, or to enhance returns. For example, a pension fund might use interest rate swaps to manage its bond portfolio’s sensitivity to interest rate changes. Their substantial capital and long-term investment strategies add depth to the derivatives market.
Banks and financial institutions participate significantly in risk management and as intermediaries, offering derivatives products to retail and institutional clients. They use derivatives like currency swaps and interest rate futures to hedge risks associated with their operations. By providing these services, they help ensure the smooth functioning of the market and provide liquidity for other participants.
Retail traders are individual investors who trade derivatives through brokers. While their trade volumes are smaller compared to institutional participants, retail traders still contribute to market liquidity. They may engage in speculation or use derivatives as part of their portfolio to hedge against risks. Their participation has grown significantly in recent years, particularly with the advent of online trading platforms, which are making derivatives more accessible.
Exchanges such as the National Stock Exchange (NSE) provide the infrastructure for derivatives trading. They ensure that transactions are transparent, secure, and conducted in an organised manner. Exchanges facilitate the buying and selling of derivative contracts, and their role is crucial in maintaining order in the market, as they establish standardised contracts, oversee clearing and settlement processes, and act as intermediaries.
Derivative trading is a complex yet interesting concept. One of the main advantages of derivatives is that you don’t require any special tools or technologies to start trading in them. By opening a Demat account and a trading account in India, you can get started with buying and selling derivatives. If you’re a beginner and are just starting trading, it is advisable to perform adequate research before venturing into the derivative segment.
Yes, derivative trading can be profitable but carries higher risks than traditional investing. Traders can profit from rising and falling markets using instruments like options and futures. However, success requires a solid understanding of the market, strategies, and risk management.
The three key derivative rules are:
1) Use leverage cautiously, as small price movements can lead to significant gains or losses.
2) Understand the underlying asset thoroughly.
3) Always implement risk management strategies like stop-loss orders to protect against unexpected market fluctuations.
No, derivatives are generally considered high risk due to their use of leverage. While they allow traders to control larger positions with a smaller initial investment, this can magnify losses if the market moves unfavourably. Risk management strategies are crucial when trading derivatives.
No, derivatives and futures are not the same, though futures are a type of derivative. A derivative is any financial instrument whose value is based on an underlying asset, such as stocks, bonds, or commodities. Futures contracts are agreements to buy or sell an asset at a predetermined price on a specific date.
Yes, it is possible to lose money with derivatives. Due to the leverage involved, losses can exceed the initial investment, especially if market movements go against your position. Risk management tools, such as stop-loss orders, can help limit potential losses in derivative trading.
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