What are derivatives?
A derivative is a contract between two parties. The two parties involved are the investors interested in doing derivative trading. These investors speculate and bet on the possible future prices of an asset. The asset can be anything from stocks, commodities, currency to interest rates. So a derivative is a financial instrument which derives its value from an underlying asset on which the bet is placed.
The value of these underlying assets keeps fluctuating. These changes in value can help an investor to earn profits from derivative trading.
Types of Derivative Contracts
1. Futures Contract
Futures contracts are the ones wherein the investor has agreed to buy or sell assets at a specified time in the future for a specified price which is agreed upon the day of the contract. It is like a bet between two parties. For, e.g., There are two parties, X and Y. X owns 10,000 shares of a company and fears that the value of the shares might decline. To avoid losses and save the value of the stocks, X decides to arrange for a futures contract. Y is a speculator, who thinks that the value of shares held by X will increase. X and Y both get into an agreement through the futures contract based on X’s current value of shares.
If the price of shares increases in the future, then X suffers losses and Y earns the profit and vice versa.
Future trading is done on the exchange. The size of the lot in derivative markets is specified, so you cannot buy a single share in a futures contract. There is also on expiry date to the contract. People usually prefer to opt for a futures contract to hedge a certain amount of risk.
2. Forwards Contract
If, in a futures contract the price is agreed upon and the buying and selling take place in the future, then in the forwards contract the date for buying or selling is pre-decided, and the assets are sold or bought based on the price on the day of transaction. Forward contracts are traded over-the-counter.
3. Options Contract
Options contracts are quite similar to future contracts. In options contract, you get the right to buy or sell an asset at a predetermined price. But there is one important difference. When you buy an options contract, there is no obligation on you to fulfill the contract or adhere to the terms of the agreement. For, e.g., if you have agreed to buy 200 shares of a company, you have the right to buy them. But it is not compulsory to do so. You can change your mind and chose not to buy or sell. The buyer has to pay a premium amount to get the right to buy the asset. So in case if the prices fall and the buyer opts out, the premium is the only loss he has to incur.
The right to buy is called ‘Call Option’ and the right to sell is called ‘Put Option’.
If you are selling an option contract, then seller has the obligation to fulfil if the buyer of option decides to exercise it. Options trading is done on both Over-the-counter and in exchanges. This type of trading requires you to have a better understanding of the market and its fluctuations to avoid losses.
Swap Contract is a very complex derivative. In Swaps, you can change your cash flow from uncertain to certain. This is most commonly done in regards to interest rates and currency. You can swap your fixed interest rate to a floating interest rate. These contracts are not traded on the exchange but are private agreements between two parties. In India, the swap market does not see many takers as the market is highly illiquid.
Uses of Derivative Trading in India
Transfer of risk
As the derivative markets have takers who are highly motivated to take up risks, a trader who does not want to take risks can transfer it to these risk takers in the market.
This is where you can earn profits dues to the inefficiencies in the market. Derivatives trading involves good returns because of the arbitrage strategy.
Earn Without Physical Settlement
In any trading to get the final income, you need to settle the trade. In derivatives trading, you don’t need actually to sell your shares, but you can earn profits through contracts in case of price fluctuations.
Protection for Securities
Depending on your hedging strategy, you can protect your security from a high rate of losses.
Participants in Derivative Trading
Derivatives trading in India involves the following participants. These participants are the financial intermediaries who provide enough liquidity in the market.
Investors who want to save themselves from the risks of price movements are called hedgers. They partake the process of hedging their investments by doing an opposite trade in the derivatives market to reduce the impact of such fluctuations. The risk is then transferred to somebody who is agreeing to bear it.
Speculators are the ones who have a healthy appetite for risks. If hedgers are risk aversive, then speculators are the ones who keep looking for opportunities for high risks, hoping to gain high returns. Speculators provide the market a high level of liquidity.
Margin traders are the ones who do margin trading. Margin trading is when you only have to pay a fraction of the total sum. The fraction paid is called margin. This process involves high leverage. There is a fixed limit to how much you can borrow from the broker.
There is a possibility that the price of an asset in the cash market differs from its price in the derivatives market. A trader who makes the most of this inefficiency is known an Arbitrageur. For, e.g., if the value of a share is Rupees 200 per share in the cash market and the same share is quoted at Rupees 210 in the futures market. An Arbitrageur would buy 1000 shares at rupees 200 in the cash market and at the same time sell 1000 shares at Rupees 210 in the future market and earn rupees 10 profit each share.
How to do Derivative Trading in India?
There are some basic steps involved which you have to follow when you start derivative trading. They are as follows:
- When it comes to derivative trading, you need to do a good amount of research to strategize. Everything depends on the strategy that you make for trading.
- Make sure that you have an account which lets you trade in derivatives. Always keep your trading account filled with the required amount of money.
- You also need to have a demat account.
- Hire a broker to ease you through the process. The broker will also help you to trade derivatives online.
- You can trade derivatives through an exchange or over-the-counter. Trading through the exchange is standardized whereas an OTC is a private agreement between two parties and is not standardized.
- Always select your stocks carefully. Make a note of your margin amount available, the price of the underlying share and also the price of the contracts. Make a budget and see if all of this fits in that budget.
- In futures and options trading, you have the option to settle the trade before the expiry date. For this, you either have to pay the whole amount outstanding or enter into an opposing trade.
Why Trade in Derivatives
Derivative trading opens avenues for a high trading exposure. The low rate of margins involved in trading helps you to leverage on high levels and incur minimum losses.
Derivative trading brings in more liquidity because of high leverage. Liquidity is what attracts investors to invest in derivatives.
Hedging is common in derivative markets. When you hedge position you protect yourself from potential losses.
Every investment involves risks. In derivatives trading, you get to choose between a high risk and a conservative risk strategy which is based on the predicted rise or fall of stock price.
Higher Chance of Returns
No matter which way the market moves, there are chances that you might incur good returns in derivative trading, given that your strategy is perfect.
Difference between Futures and Options
In India futures and options trading is preferred by investors as a go-to option to trade in the derivatives market. Listed below are the various difference between f&o trading.
Profit or Loss Potential
Futures have an unlimited potential for both, profits and losses.
Options have a limited loss potential and unlimited profit potential.
In a futures contracts if a buyer agrees to buy or sell an asset on a specified date in the future, then he is obligated to do so.
In options contracts, the buyer gets the right to buy an asset at a decided price. Though there is no obligation to do the purchase. If the buyer purchases the asset, then the seller has an obligation to sell it to the buyer.
Even if there is a drop in the agreed price, the buyer will have to buy the asset and incur losses in futures trading.
In options trading, if the buyer sees a drop in the prices, then he can choose to opt out from the situation and incur minimum losses.
Execution of Contract
In futures trading, the contract execution takes place on the specified date. That date is when the buyer purchases the underlying asset.
In options trading, the contract execution can take place at any time but before the expiry date.
Payments in Advance
There are no advance payments in futures contract except the eventual payment for the asset.
In options trading, the buyer pays a premium to get the right to buy the asset.