Derivatives are financial contracts that derive value from an underlying asset. They allow investors to speculate on price movements, hedge against risks, or enhance portfolio returns. In this article, learn about derivatives in detail, their types, participants, how to trade, pros and cons.
What are Derivatives?
The value of derivatives depends on an underlying asset, such as bonds, stocks, market indices, commodities and currencies. These underlying assets’ values keep fluctuating as per the market conditions. Therefore, the basic idea of trading in the derivatives market is to earn profits by predicting the future value of the underlying asset.
For example, you have invested in a stock at the market price. As the stock price keeps fluctuating, it can lead to loss if its value declines. In such a situation, you can enter a derivative contract. You can use it to speculate correctly on the price movement, aiming to secure gains through accurate predictions. Alternatively, you can use derivatives to safeguard yourself against losses in the actual stock market, effectively providing a protective shield if the stock’s price moves unfavourably.
Types of Derivatives
There are 4 main types of derivative contracts, such as futures, options, forwards and swaps.
Forwards
It is a customised contract between two parties to buy or sell an asset at a predetermined price at a future date. It is to be noted that forwards are not traded on any central exchanges but over the counter and that they are not standardised to be regulated. Therefore, it is mostly useful for hedging and minimising risk even though it doesn’t guarantee profit. Over-the-counter Forwards are exposed to counterparty risk as well. Counterparty risk is a kind of credit risk in which the buyer or seller might not be able to keep their part of the obligation. If the buyer or seller becomes insolvent and is not able to deliver on their part of the bargain, the other party may not have any recourse to save their position.
Futures
Futures are similar to forwards but slightly differ regarding the obligation. Futures are standardised contracts where both parties are obligated to perform the contract. These financial contracts are traded on the stock exchanges.
Options
These contracts grant the buyer the right to buy or sell the underlying asset at a predetermined price within a specified timeframe. The buyer has the choice to exercise this right, while the seller, referred to as the option writer, is obligated to fulfil the contract. If the buyer doesn’t want to continue with the options contract, they can just pay the premium to the option’s writer and pass on the exercise.
Swaps
These are a form of financial derivative commonly used to exchange one kind of cash flow with another. Swaps are not traded in exchanges but are private agreements between parties and are mostly traded over the counter.
The most common types of swaps are currency swaps and interest rate swaps. For example, a trader may use an interest rate swap to change from a variable-interest loan to a fixed-interest loan or vice versa.
Who Participates in the Derivatives Market?
The derivatives market involves a wide range of participants, each with their own objectives and roles. Here are the key participants in the derivatives market:
- Hedgers: These are participants who use derivatives to protect themselves from potential price fluctuations in the underlying asset. Their primary goal is to reduce risk. For example, a farmer might use futures contracts to hedge against a drop in the price of the crops they will harvest in the future.
- Speculators: These are individuals or entities who actively seek to profit from price movements in the derivatives market. They do not have an underlying exposure to the asset but take positions based on their expectations of future price changes. Speculators can include individual traders, hedge funds, and other financial institutions.
- Arbitrageurs: These participants aim to exploit price differentials between related assets or markets. They buy low and sell high to profit from price inefficiencies. Arbitrageurs help maintain price consistency across different markets and are crucial for market efficiency.
- Margin Traders: These traders deposit a minimum amount, known as a margin, with the broker to take part in the derivative market. This deposit tracks daily profits and losses based on market fluctuations. Margin trading offers leverage, allowing traders to control larger positions. For example, you bought 100 shares of XYZ Ltd for ₹1 lakh. In the derivative market, the same amount lets you own a larger position.
How To Trade Derivatives?
Before trading in financial derivatives, it’s crucial to understand the dynamics of the market along with the different types of derivatives. Educate yourself about the current market conditions and the factors poised to influence them. Financial markets are sensitive to economic, political, and social factors, any of which can trigger substantial shifts. Being informed and prepared for these developments is vital.
Steps To Trade in the Derivatives Market
- Open an online trading account with a trusted broker like Angel One.
- To start trading in derivatives, you need to pay a margin amount, which is locked once the contract is executed and the trade settles. If the margin amount is less and below the minimum required, you will be prompted for a margin call to rebalance it.
- Ensure you have good knowledge about the underlying asset. Also, it is important to have enough funds in the contract till the trade is settled.
Advantages of Derivatives
- Hedging risks: Hedging risk is to reduce risk in one’s investment by making another investment, and derivatives are the best option to do so. Derivatives are used with the objective of minimising risk in the market.
- Low transaction costs: Trading in the derivatives markets includes low transaction costs as compared to other securities like shares or bonds. As derivatives basically act as a risk management tool, it ensures lower transaction cost.
Disadvantages of Derivatives
- High risk: As these instruments derive their value from the underlying asset, changes in the value of the underlying asset impact these contracts immensely. The prices of the underlying assets, like shares, bonds, etc., keep changing according to market conditions and are unpredictable.
- Speculative nature: Derivatives are the common tool used for speculation to earn profits. The unpredictable nature of the market makes speculation highly risky and may result in huge losses.
Conclusion
Derivatives are not only highly risky, but they are also necessary for investors to reduce risk in a volatile market. It is important to have extremely good knowledge about the derivatives to trade in the derivatives market to ensure less risk and high profit. As derivatives are leveraged instruments, they can cut both ways when it comes to profit or loss, and therefore, a lot of research and understanding is necessary in this market.
To trade in equity derivatives, it is important to have a Demat account. Open a Demat Account today on Angel One for free!
FAQs
Why do investors enter a derivatives contract?
Investors enter derivatives contracts to hedge against price fluctuations, speculate on price movements, or diversify their portfolios. These contracts can help manage risk and offer profit opportunities.
Are derivatives and futures different?
Futures are a type of derivative contract. While all futures are derivatives, not all derivatives are futures. There are different types of derivatives, including futures, options, swaps, and forwards. Futures are a specific type of derivative that obligates the buyer to purchase or the seller to sell an asset at a predetermined price on a specified future date.
Are derivatives risky?
Derivatives are used for hedging to lower risk exposure on various underliers. However, trading alone in derivatives involves risks such as market volatility, counterparty risks, interconnection risks, and liquidity risks.
Is it mandatory to have a trading account and a demat account to trade in derivatives?
A trading account is mandatory to invest in derivatives. However, in the case of a demat account, it depends on the type of derivatives you are picking. For commodity derivatives, a demat account may not be required, and for equity derivatives, you must need a demat account.
What are the 4 types of derivatives?
Derivative contracts can be categorised into four major types, namely, forward contracts, futures contracts, options contracts and swaps. In forward and futures contracts, two parties agree to buy and sell the underlying asset at a specified price on a future date. Options contracts provide the buyer of the contract the right (not the obligation) to buy or sell the underlying asset at a specified price on a future date. Swaps, on the other hand, are agreements where two parties agree to exchange cash flows, revenue or liabilities.
What are the basics of derivatives?
Derivatives are financial contracts whose value is derived based on the performance of an underlying asset. The underlying asset can either be stocks, commodities, currencies or even market indices. Derivative contracts enable investors to hedge their risk by taking on contrarian positions. Traders also commonly use derivative contracts to generate income by speculating on the price movements of the underlying asset.
