by Derivatives are essentially contracts that derive their value from an underlying asset. The underlying asset can be stocks, commodities, currencies, indices, exchange rates, or even interest rates. Derivative trading involves both buying and selling of these financial contracts in the stock market. With derivatives, you can make profits by predicting the future price movement of the underlying asset.
Derivative contracts can be classified into two types; Futures and Options. A future is basically a contract between a buyer and a seller, who agree to buy and sell a specific underlying asset at a future date. Similar to futures, option contracts give the buyer and the seller the right to buy and sell the underlying asset at a specific price at a future point in time. An option, on the other hand, is again sub-classified into two types; call option and put option.
However, there’s a key difference between these two futures and options. In the case of options, the buyer or the seller can either choose to exercise their right to buy or sell, or they could allow that right to lapse upon the expiry of the contract. With futures, both the buyer and the seller are obligated to honor the contract upon expiry.
Derivative contracts are short-term financial instruments that come with a fixed expiry date, which is generally the last thursday of every month. At any point in time, both futures and options contracts trade with three different expiry dates spanning over three months.
Types:
Futures: A futures contract is a legal agreement between two parties to buy or sell the underlying asset at a predetermined future date and price. The contract is executed directly through a regulated and organised exchange.
Forwards: Forward contracts are similar to futures except the deal is not made through an organised or regulated exchange. Since these are Over-The-Counter (OTC) contracts, they carry more counterparty risk for both parties involved.
Options: An options contract gives a trader the right but not an obligation to buy or sell an underlying asset at a predetermined future date and price.
Swaps: A swap is a contractual agreement between two parties to exchange cash flows at a future date based on a pre-planned formula. Similar to forwards, they are OTC contracts and consequently not traded on exchanges.
Participants:
Traders and speculators: They predict future changes in the price of an underlying asset. Based on these predictions, they take a certain position (long or short) in a derivative contract.
Hedgers: These participants invest in the derivatives market to eliminate the risks associated with future price changes.
Arbitrageurs: Arbitrage is a practice often adopted by traders to exploit the price differences in two or more markets. For example, a trader purchases stock in one market and simultaneously sells it off at a higher price in another. It is a common practice in financial markets.
Margin traders: In derivative trading, a margin is an initial amount an investor has to pay to the stockbroker. It is only a percentage of the total value of the investor’s position. Margin traders use this distinct payment feature to buy more stocks than they can afford.
Uses:
Earn money on shares that are lying idle
So you don’t want to sell the shares that you bought for long term, but want to take advantage of price fluctuations in the short term. You can use derivative instruments to do so. Derivatives market allows you to conduct transactions without actually selling your shares also called as physical settlement.
Protect your securities against
Fluctuations in prices the derivative market offers products that allow you to hedge yourself against a fall in the price of shares that you possess. It also offers products that protect you from a rise in the price of shares that you plan to purchase. This is called hedging.
Benefit from arbitrage
When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets.
Transfer of risk
By far, the most important use of these derivatives is the transfer of market risk from risk-averse investors to those with an appetite for risk. Risk-averse investors use derivatives to enhance safety, while risk-loving investors like speculators conduct risky, contrarian trades to improve profits. This way, the risk is transferred. There are a wide variety of products available and strategies that can be constructed, which allow you to pass on your risk.
Advantages
Used in risk management: The value of a derivative contract has a direct relation with the price of its underlying asset. Hence, derivatives are used to hedge the risks associated with changing price levels of the underlying asset. For example, Mr A buys a derivative contract, the value of which moves in the opposite direction to the price of the asset he possesses. He’ll be able to use the profits in the derivatives to offset losses in the underlying asset.
Low transaction costs: Derivative contracts play a part in reducing market transaction costs since they work as risk management tools. Thus, the cost of transaction in derivative stock trading is lower as compared to other securities like debentures and shares.
Market efficiency: Derivative trading involves the practice of arbitrage which plays a vital role in ensuring that the market reaches equilibrium and the prices of the underlying assets are correct.
Determines the price of an underlying asset: Derivative contracts are often used to ascertain the price of an underlying asset.
Risk is transferable: Derivatives allow investors, businesses and others to transfer the risk to other parties.
Disadvantages
Counterparty risk: Derivative contracts like futures that are traded on the exchanges like BSE and NSE are organised and regulated. But, OTC derivative contracts like forwards, are not standardised. Hence, there’s always a risk of counterparty default.
Involves high risk: Derivative contracts are highly volatile as the value of underlying assets like shares keeps fluctuating rapidly. Thus, traders are exposed to the risk of incurring huge losses.
Speculative in nature: Derivative contracts are commonly used as tools for speculation. Due to the high risk associated with them and their unpredictable fluctuations in value, baseless speculations often lead to huge losses.
