Table of content

Derivatives & Types of Derivatives

Table of content

Understanding Derivatives

Let us begin by answering the most obvious question – “What is a derivative?” Derivatives are financial tools whose worth is determined (or derived) by the movements of an underlying asset, which could be stocks, bonds, commodities, or market indices. They serve as contracts between two parties, enabling them to buy or sell the underlying asset at a predetermined price on or before a specified date. Essentially, derivatives allow you to bet on the future price movements of assets without owning them outright.

They come in various forms, including forwards, options, futures, and swaps. These instruments enable you to hedge against risk, speculate on future price movements, and optimise portfolio returns.

How Derivatives Function

Derivatives derive their value from the price fluctuations of the underlying asset. They operate on the principle of leverage, allowing you to control a larger position with a smaller upfront investment. For example, futures contracts enable you to buy or sell an asset at a predetermined price on a future date. If the price of the underlying asset moves in your favour, you can profit from the difference between the contract price and the market price at expiration. But remember, by leveraging derivatives, you can amplify potential returns, but you also expose yourself to greater risk.

Let's consider an example:

Imagine you're interested in purchasing 100 shares of Company X, currently trading at ₹ 1,000 per share. However, you're uncertain about the stock's future price movement. Instead of purchasing the shares outright, you opt for a derivative contract known as a futures contract.

You enter into a futures contract to buy 100 shares of Company X at ₹ 1,000 per share, with an expiration date three months from now. Now, suppose the price of Company X's shares rises to ₹ 1,200 per share by the expiration date. Since you've locked in the purchase price at ₹ 1,000 per share through the futures contract, you stand to profit ₹ 20,000 (₹ 200 per share × 100 shares) from the price difference.

Conversely, if the price of Company X's shares declines to ₹ 900 per share by the expiration date, you're still obligated to purchase the shares at ₹ 1,000 per share as per the terms of the futures contract. In this scenario, you incur a loss of ₹ 10,000 (₹ 100 per share × 100 shares) due to the price difference.

This example illustrates how derivatives work by enabling investors to speculate on the future price movements of underlying assets without owning them outright. Derivatives offer opportunities for both gains and losses, depending on the direction of price movements.

Exploring the Different Types of Derivatives

  • Forwards:

    Forwards are customised contracts between two parties to buy or sell an asset at a future date for a predetermined price. They are traded over-the-counter and offer flexibility in terms of contract specifications.
  • Options:

    Options provide the buyer with the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price (strike price) on or before a predetermined date (expiration date). Options offer leverage and limited risk exposure.
  • Futures:

    Futures contracts are standardised agreements to buy or sell an asset at a predetermined price on a specified future date. They are traded on exchanges and offer liquidity and price transparency.
  • Swaps:

    Swaps are agreements between two parties to exchange cash flows or other financial instruments based on predetermined terms. They are commonly used to hedge against interest rate or currency fluctuations.

Step by Step Guide to Derivative Trading

Trading derivatives involves opening an account with a brokerage firm, conducting thorough research, analysing market trends, and executing trades through the broker's platform. It's essential to understand the terms, risks, and mechanics of each derivative before engaging in trading activities to mitigate potential losses. Here are the steps involved:

  • Research and Education:

    Before diving into derivative trading, it's crucial to educate yourself about the different types of derivatives, their mechanics, and their associated risks. Take advantage of educational resources, books, online courses, and seminars to gain a solid understanding of derivative trading.
  • Select a Brokerage Firm:

    Choose a reputable brokerage firm that offers derivative trading services. Consider a platform, like m.Stock, that provides access to a wide range of derivative products, competitive pricing, robust trading tools, and educational resources.
  • Open a Trading Account:

    Once you've selected a brokerage firm, open a trading account specifically designed for derivative trading. Follow the account opening procedures, complete the necessary documentation, and fund your trading account with the required initial deposit.
  • Learn the Trading Platform:

    Familiarise yourself with the brokerage firm's trading platform and tools. Learn how to place orders, monitor positions, analyse charts, and access real-time market data. Practice using the platform through demo accounts to gain confidence before trading with real money.
  • Conduct Market Analysis:

    Before placing trades, conduct a thorough market analysis to identify potential trading opportunities. Analyse market trends, study price charts, and monitor economic indicators and news events that may impact the underlying assets of the derivatives you're interested in trading.
  • Develop a Trading Strategy:

    Based on your market analysis, develop a trading strategy that aligns with your risk tolerance, investment goals, and time horizon. Define entry and exit points, set stop-loss and take-profit levels, and establish risk management rules to protect your capital.
  • Place Trades:

    Once you've identified a trading opportunity and formulated a strategy, execute trades according to your plan. Enter the appropriate order type, specify the quantity, price, and expiration date (if applicable), and review your order before submission.
  • Monitor Positions and Manage Risk:

    After placing trades, monitor your positions closely and adhere to your trading strategy. Adjust stop-loss levels, take profits, or exit trades if market conditions change or your original thesis no longer holds. Continuously evaluate and manage risk to protect your capital and preserve profits.
  • Review and Learn:

    After each trading session, review your trades, analyse performance, and identify areas for improvement. Learn from both successful and unsuccessful trades to refine your trading strategy and enhance your skills as a derivative trader.

Who Are the Participants in the Derivatives Market

  • Hedgers:

    Hedgers use derivatives to protect against adverse price movements in the underlying asset. They aim to mitigate risk and stabilise returns by locking in prices through derivative contracts.
  • Arbitrageurs:

    Arbitrageurs capitalise on price discrepancies between derivative contracts and the underlying asset to make risk-free profits. They exploit inefficiencies in the market to buy low and sell high.
  • Margin Traders:

    Margin traders use leverage to amplify their trading positions in derivatives, potentially magnifying both gains and losses. They must maintain margin requirements to cover potential losses and manage risk effectively.

Derivatives Trading: Advantages

Here are some advantages of derivatives trading:

  • Risk Management:

    Derivatives allow investors to hedge against adverse price movements and manage portfolio risk effectively.
  • Leverage:

    Derivatives offer the potential for amplified returns through leverage, enabling investors to control larger positions with a smaller capital outlay.
  • Price Discovery:

    Derivative markets facilitate price discovery by reflecting the collective expectations and sentiments of market participants, providing valuable insights into future price movements.
  • Portfolio Diversification:

    Derivatives provide opportunities for portfolio diversification by gaining exposure to a wide range of assets and markets, enhancing overall portfolio resilience.

Derivatives Trading: Drawbacks

Here are some disadvantages of derivatives trading:

  • Leverage Risk:

    Leverage can magnify both gains and losses, exposing investors to significant risk if the market moves against them.
  • Counterparty Risk:

    Derivatives entail counterparty risk, where one party may default on its obligations, leading to financial losses for the other party.
  • Complexity:

    Derivatives can be complex financial instruments that require a thorough understanding of their mechanics and risks before trading, increasing the potential for misinterpretation and loss.

In Summation

Derivatives are powerful financial instruments that offer opportunities for risk management, speculation, and portfolio enhancement. By understanding the types, mechanics, and pros and cons of derivatives, you can make informed investment decisions and navigate the complexities of financial markets with confidence.

Frequently Asked Questions

A derivative is a financial contract whose value is derived from the performance of an underlying asset. Unlike traditional investments like stocks or bonds, derivatives do not involve ownership of the underlying asset but rather provide exposure to its price movements through contractual agreements.

Leverage in derivatives can be both positive and negative, depending on how it's utilised. Positively, leverage allows you to control larger positions with a smaller upfront investment, potentially amplifying returns. However, it also magnifies the impact of price movements, which can lead to substantial gains or losses. Therefore, it's essential for investors to understand and manage leverage carefully to mitigate potential downsides.

The limitations of derivatives include the potential for significant losses due to leverage, counterparty risk, market volatility, and complexity. Additionally, derivatives may not always accurately reflect underlying asset values, leading to mispricing and potential losses for investors. It's essential for investors to understand these limitations and carefully assess the risks before engaging in derivative trading.

Although derivatives trading involves some risks, you can mitigate them to make it safe. This can be done by conducting thorough research and education, diversifying your derivative holdings, using risk management tools such as stop-loss orders and position sizing, and staying disciplined with your trading strategies. Additionally, maintaining adequate liquidity and monitoring market conditions can help minimise potential losses.

Several factors affect the pricing of derivatives, including the price of the underlying asset, time until expiration, volatility of the underlying asset's price, interest rates, and dividend yields. These factors collectively determine the intrinsic value and time value of the derivative contract.

Derivatives offer several advantages, including risk management through hedging against adverse price movements, leverage to amplify potential returns, price discovery through reflecting market expectations, and portfolio diversification by gaining exposure to various asset classes and markets.

Derivatives entail risks such as leverage risk, where small price movements can result in significant gains or losses, counterparty risk, where one party may default on its obligations, market risk due to fluctuations in underlying asset prices, and liquidity risk if derivatives cannot be easily bought or sold.

Various market participants engage in derivative trading, including hedgers who use derivatives to manage risk, arbitrageurs who exploit price discrepancies for profit, speculators who seek to profit from price movements, and margin traders who use leverage to amplify returns.

Derivatives are sophisticated financial instruments that may not be suitable for beginners. They require a good understanding of their mechanics, risks, and market dynamics. You should carefully assess your risk tolerance, investment objectives, and knowledge before trading derivatives.

Derivatives come in various forms, including forwards, options, futures, and swaps. Each type has unique characteristics and uses. Forwards are customizable contracts between two parties, options provide the right to buy or sell an asset at a specified price, futures are standardised agreements traded on exchanges, and swaps involve the exchange of cash flows or other financial instruments.

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