Understanding Derivatives

As the name implies, derivatives are financial instruments whose value is derived from another asset or instrument. 

Let’s break this down with a relatable example: 

Imagine a farmer expects to harvest 100 kg of wheat. He strikes a deal with a trader — in two months, he’ll sell this wheat at ₹50/kg, totaling ₹5,000. If wheat prices rise to ₹60 in two months, the trader ends up with wheat worth ₹6,000 at the agreed ₹5,000 rate. 

What just happened? A contract based on the future price of an underlying asset (wheat) was created. This contract is what we call a derivative. 

In financial markets, derivatives are formalized into standardized contracts traded on exchanges. Unlike one-on-one deals like in our example, exchange-traded contracts define fixed quantities and terms. This standardization fuels higher trading volumes and liquidity. 

Types of Derivatives 

The most traded derivatives in India are futures and options, often grouped under the term F&O. 

There are also forwards and swaps, but these are typically over-the-counter (OTC) instruments and not exchange-traded, hence less relevant to everyday traders. 

Futures Contracts 

A futures contract obligates a seller to deliver, or a buyer to accept, a specific quantity of an asset (say, a stock) at a predetermined price on a set date. 

Why trade futures? 
Many traders do so to speculate and profit. Futures involve leverage, meaning a small price movement can yield significant gains or losses. Traders can magnify outcomes without investing the full price upfront. 

They are also used for hedging, helping traders lock in entry or exit prices and manage market risk more effectively. 

Options Contracts 

Options, unlike futures, offer rights without obligations. For instance, if you expect a stock to rise, you might buy its call option, allowing you to buy the stock later at specific price by paying a small premium. 

If the price rises, you gain. If it doesn’t, your loss is limited to the premium. 

We’ll explore more about options in the upcoming module. 

Why F&O Is Popular? 

The explosive popularity of F&O trading has attracted many traders in recent years, especially those looking for quick and substantial returns. 

Why Traders Like F&O? 

• Leverage: A built-in feature of F&O that amplifies potential profits (and risks). 

• Small Capital, High Hopes: Many new traders enter the market with ₹1–2 lakh, aiming to earn ₹20,000–₹30,000 monthly. That’s a 20–30% monthly return—ambitious and risky. 

The Reality Check: 

• Expecting 20% returns monthly is not impossible but highly risky. 

• Such results require aggressive strategies, increasing the chance of losses. 

• Most newcomers underestimate the risk and often lose their capital quickly. 

Are Derivatives Risky? 

Absolutely! They are as risky as a sharp knife in untrained hands. 

That said, F&O isn’t inherently bad. In fact, when used with skill and discipline, it offers flexibility that even allows traders to reduce or eliminate risk, albeit with lower returns. 

Success in Derivatives Comes From: 

• Learning deeply about how derivatives work. 

• Respecting the risks and managing them mindfully. 

• Starting small, accepting initial mistakes as part of the journey. 

• Building a system based on logic and discipline, not emotions. 

With these principles, traders can make the most of what F&O offers. As you move through upcoming modules on futures and options. Remember: knowledge and control are your greatest allies. 

Points to Remember 

• Derivatives are financial contracts that derive value from an underlying asset. 

• Futures and options are the most traded derivatives in India. 

• F&O carries high risk and reward, requiring careful strategy and understanding.