Derivative trading has long been one of the most common forms of trading in India and even globally.
Trading with derivatives in India and abroad refers to trading on a product referred to as a derivative, the value of which is derived from the value of its underlying assets.
Derivatives in India are governed by the Securities and Exchange Board of India (SEBI). In its annual report for 2019-20, the regulator stated that it was looking into studying the “feasibility of introduction of freight derivatives in the commodities derivatives market”.
While currently contracts on the same commodities can be traded on multiple exchanges so as to offer choices and competition to investors, SEBI has stated that it may be exploring allowing a commodity to be traded on only one exchange.
Even as SEBI works out the nitty grittier of derivatives finance through freight, it is important to learn about what this means for the Indian market. Read on to learn more.
Freight Derivatives
Freight refers to goods that are transported in bulk, mainly for industrial purposes. These could include goods transported by ship, air, rail or road. Derivatives whose value is derived from future levels of freight rates are known as freight derivatives.
Freight derivatives, in countries where they are legally traded, often see trading by end-users such as grain houses and ship owners, as well as suppliers such as international trading corporations and integrated oil companies. This is done to offer protection by mitigating the risk and hedging against the volatility of price within the supply chain.
How Freight Derivatives Work
Freight rate indexes are released by the Shanghai Shipping Exchange and the Baltic Exchange. The designated clearinghouse sees the cleared contracts being margined on a daily basis. The end of the trading day sees investors either receiving or owing to the difference of the trade between the market index and the paper contracts.
Since shipping markets bear a high amount of risk, freight derivatives are a lucrative prospect for shipowners and operators along with trading companies, oil companies, and grain houses, who wish to manage the risk of freight rates.
Derivatives Currently Being Traded in India
In India, the most popular derivatives instruments are futures, options, forwards, and swaps contracts.
Futures:
With this type of instrument, two parties enter into an agreement for buying or selling an asset at a specified time period in the future, on a previously agreed-upon price.
Options:
With an options contract, an investor buys the right but without the obligation to buy or sell the underlying asset on a previously agreed-upon date at an agreed-upon price. The buyer gains the right to exercise their option by paying a premium while the writer of the option receives the premium and is obligated to buy or sell the underlying asset if the option buyer chooses to exercise their option.
Forwards:
Under this type of instrument, two parties enter into a contract to sell or purchase an underlying asset for a predetermined price on a predetermined date. Regardless of the price of the asset on the date previously agreed upon, both parties are obligated to fulfill the transaction.
Swaps:
An agreement for the future between two parties, swaps sets a formula for the exchange of cash flows. Swaps are a good investment for investors who wish to balance the risks that come with currency exchange rates as well as volatile interest rates.
How to Trade in Derivatives Market
Derivatives finance can feel tricky when you first begin investing in the instruments. It can feel confusing since the value of the investment itself is derived from the value of underlying assets. However, there are several ways to prepare for investing in the derivatives market and ensure that you are not making any accidental errors or spoiling your chances of gaining high returns. Read on to learn tricks that can best help you trade in the derivatives market in India.
Conduct thorough research:
The most important piece of advice you will receive regarding investing in any instrument is the need to conduct thorough research on the instruments and the market. This is important to be able to anticipate the movements of the market and your instruments. Trading in the derivatives market requires you to assess market conditions in a periodic manner, wherein you keep an eye on changes occurring in the market and assess its future value.
Arrange a requisite market amount:
While trading in derivatives, it is important to maintain extra funds in your account. Margin amounts relate to the amount used by traders to initiate a trade in the market. However, since this margin amount can change based on the underlying stock’s price, it could be helpful to have additional funds in your account.
Get the proper trading account:
There are several types of accounts available in the market for traders, but it is important to get an account that aligns itself with your individual goals. Different people may have different financial goals, and banks and financial institutions today are offering different types of accounts in a bid to cater to every kind of investor. While getting an account, make sure the account has everything that you require in order to trade comfortably. You can also choose to have the services activated on an existing account, which will allow you to place trades through the phone or online.
Maintain your margins:
There are several considerations you should keep in mind while selecting your stocks and the contracts on them. These decisions should be made in line with a range of factors, including the liquid funds you currently possess, requirements of margins, price of underlying assets, contract prices, etc. It is important that these factors be considered carefully before you take a call on which instruments to invest in.
Regardless of the kind of instruments you invest in, it is always necessary to remain prepared for volatility in the market and take precautions accordingly. Being prepared for changes in the market lets you take adequate precautions and prepare ahead of any unexpected turbulence.
