Derivative Contracts: Meaning, Types, and Market Participants
Many traders indulge in derivatives trading to profit from fluctuations in the stock market. However, to take advantage of market volatility, you need to have a clear insight into this segment.
Keep reading this blog for detailed insights.
What are Derivatives?
Derivatives are financial contracts that are used by traders for speculation, hedging a position, or leveraging holdings. They are executed between two parties and have an underlying asset that helps determine their value. These assets can range from stocks, currencies, market indices, commodities, etc.
The values of these assets continuously fluctuate during a trading session. Traders who trade derivatives anticipate making money by placing a bet on the future price of these underlying assets.
Let’s take the help of an example for better understanding.
Suppose there is a cotton trader who is concerned over the fluctuations in commodity value in the coming months. He plans on selling his produce at the current market price of ₹10,000 per quintal after 6 months, but there is no guarantee that the price of cotton will not fall.
So, he enters into an agreement with a cloth manufacturer to sell his product at ₹10,000 per quintal after 6 months, regardless of the current market value after 6 months. Under such circumstances, if the price of cotton rises to ₹12,000 or falls to ₹9,000, the trader and the cloth manufacturer are bound to execute the contract at the specific price on the date of expiry.
This is how a derivatives contract works. Here, the underlying asset is the cotton (commodity) from which the contract is deriving its value.
Who are Derivative Market Participants?
Hedgers are usually producers or manufacturers of underlying assets that are used in derivatives trading. They use this strategy to reduce the risk of exposure and make sure that they get a predetermined price for their assets in case they depreciate in the future.
Speculators are traders who assess the market trends of the underlying assets by regular price monitoring and assessing various other market factors. Then, seeing the opportunity, they enter into a derivative contract and square off the trade before the expiration date to secure profits.
Arbitrageurs are traders who benefit from the mispricing of assets in the financial markets. These individuals usually realise profits from low-risk market imperfections.
What are the types of Derivatives?
Options are financial contracts in which the holder has the right but not the obligation to purchase or sell an asset at a predetermined price on a predetermined expiry date. They help mitigate future risks in case the markets are volatile.
However, this derivative option has one significant risk. The parties involved in the contract have no legal obligation to hold up their end of the bargain. The buyer can decide not to execute the contract at any point in time. They pay the premium amount for this right.
Futures are financial instruments that allow two parties to enter into an agreement to buy or sell an asset at a particular price on a specific date in the future. The buyer has a long position, while the seller has a short position on the asset.
These contracts provide the buyers and sellers with the right as well as the obligation to execute the agreement. Futures are also tradable on exchanges and, thus are standardised and regulated. Traders generally use these derivatives for commodity speculation.
Similar to futures, forwards are financial contracts between two entities to buy or sell a certain asset at a predetermined price in the future. Unlike futures, they are not traded on stock exchanges and thus do not undergo standardisation and are unregulated.
Investors trade them over the counter, and thus, the chances of parties not fulfilling their end of the bargain exists i.e., counterparty risk. This method is used by traders for speculation and risk minimization.
Swaps are financial derivatives that investors can use to convert one type of cash flow to another. They are private agreements between parties exchanged over the counter. The two most common instances of swaps are currency and interest rate swaps.
How to start trading Derivatives contracts?
You can start trading derivatives by following the steps given below:
Step 1: Open an online trading account on your preferred brokerage platform.
Step 2: Conduct thorough research on the underlying asset before investing.
Step 3: Pay the margin amount. Please note that you cannot withdraw this amount until the contract is completed and the trade is executed. If during a trading session the margin balance falls below the minimum balance, the trade will automatically be squared off if the amount is not deposited when a margin call is made.
Step 4: Control your position sizing and use stop-loss order to limit your losses.
What are the advantages of Derivatives trading?
- Low transaction costs
In comparison to other forms of investment like bonds or shares, trading in derivatives comes with relatively lower transaction costs. A probable reason behind this may be the fact that derivatives are only used as risk management tools.
- Hedging against risks
Derivatives can be used as a tool to hedge risks in investments. It is like making a new investment to reduce the risks of the older one. When you use derivatives to mitigate the risks in your investment, you are actually allocating funds based on the possibility that the price of your assets may appreciate or depreciate in value.
So, in case you predict volatility in the market, you can enter into a derivative contract. Thus, if your investments start to lose value, you can earn profits from your derivatives position by hedging against your market losses.
What are the disadvantages of Derivatives trading?
Despite having some significant advantages, derivatives trading has one major disadvantage. It involves a very high amount of risk. The underlying asset’s price constantly changes with market fluctuations. The risk increases multifold because of the leverage involved in the derivative segment. If you don’t control your position size, then you can lose your whole capital.
As the asset’s price is directly related to the contract value, any abrupt changes in the asset’s value severely impact the returns.
Additionally, a majority of traders use derivatives as a tool for speculation to earn profits. However, given the unpredictability of the stock market, these practices can be very risky, leading to significant losses.
Financial derivatives can be an excellent way to hedge, speculate, and earn profits. However, it all depends on market conditions and involves significant risk. So, before you utilise this strategy, make sure to conduct a thorough market analysis and take the necessary precautions.
Frequently Asked Questions
Q1. Who regulates derivatives trading in India?
Ans. Derivatives trading in India is regulated by the Securities and Exchange Board of India (SEBI).
Q2. Which body regulates the OTC derivatives in India?
Ans. In India, the Over-The-Counter (OTC) derivatives segment is regulated by the Reserve Bank of India. The regulation of this type of derivative has been an important element in the policy framework that has helped preserve systematic stability.
Q3. Are there any derivatives on the Bombay Stock Exchange?
Ans. Yes, investors can find derivatives on the BSE. BSE has reintroduced them after receiving requests from several trading members and market participants.
Q4. What derivatives are available on the National Stock Exchange?
Ans. On the National Stock Exchange, you can trade in two derivative instruments – Futures and Options. Moreover, NSE settles all the futures contracts in cash.