In the last two decades, the significance of the derivatives market in India has grown manifold. This is reflected in its annual turnover reaching a whopping ₹95,47,789 crores in March of 2021, an amount much higher than that clocked in by the cash segments. But what are derivatives to begin with? Here are derivatives decoded.
Why are ‘derivatives’ called such?
Financial contracts that can derive their underlying value from the underlying asset are known as derivatives in stock market. These contracts could be stocks, indices, bonds, exchange rates, commodities, or the rate of interest. By making a calculated bet on the future value of the underlying asset, such financial instruments can help derivatives traders earn a profit. Hence, their value is thereby derived from that asset, which is why they are referred to as ‘Derivatives‘.
Underlying assets change their value every now and then. When it comes to the stock market, stock prices fall or grow, commodity prices and exchange rates of currencies also follow suit. Such changes can aid an investor in making profits but can also result in losses if one is not careful. Here is where derivatives trading comes in handy. When you correctly estimate the future price of an asset, this can result in one of two things — either one can earn a profit, or they can have a safety net against losses.
Can you earn from derivatives?
Yes, it is not difficult to create an income stream through simply trading derivatives. Due to Futures and options being standardized contracts in the Indian market, this segment can be freely traded across exchanges. Here are a few ways in which derivatives can benefit traders.
Arbitrage is essentially buying low and selling high across different markets. When one trades using derivatives, one can maximize the benefits that come with arbitrage trading. Since the prices of the underlying assets are constantly fluctuating, one can optimize the buy low sell high strategy through derivatives trading — particularly, options trading. Another pointer is that prices across both markets may vary, which one can directly take advantage of and earn a profit from.
Earn money on idle shares
Most people do not want to sell shares they buy for the long term. Instead, they wish to take advantage of price fluctuations in volatile shares during the short term. To do so, you can use derivatives instruments. Trading on the derivatives market allows you to conduct such transactions without actually requiring that you sell your shares. This strategy is also known as opting for a physical settlement.
Protection against price fluctuations
Hedging is a common strategy employed by seasoned traders. It is the art of protecting yourself against a drop in the prices of the shares that you currently own. The derivatives market offers products that allow one to hedge against price drops. On the derivatives market, you can also find products that protect you against a sudden increase in the prices of shares that you plan to buy. In tandem, this is known as hedging.
Transferring your Risk
As of now, the most beneficial use of derivatives is the ability for one to transfer their risk feature. When trading derivatives, a risk-averse investor gets to add to their portfolio derivatives that can enhance their security. Alternatively, an investor that conducts more contrarian trades, and prefers riskier market movements get to increase their risk by adding more derivatives to their portfolio. In this manner, one can transfer risk. There are, additionally, a variety of products available and strategies that can be constructed and allow you to pass on your risk.
Types of Derivatives Contracts
In derivatives trading, there are four types of contracts one can opt for — forwards, futures, options, and swaps. Of these four, the most complex instruments are swaps which are not available for stock market trading.
- Futures and forwards: In a futures contract, one agrees to sell or buy a set of assets at a specified time in the future for a specified amount. Forwards are futures that aren’t standardized. For this reason, they are not traded on a stock exchange. Keep in mind that, in the derivatives market, buying a contract for a single share is not possible. You always have to purchase a lot of specified shares that have an expiration date. The process is different for forwarding contracts, as they can be tailored to suit your preferences.
- Options: Options contracts are quite similar to futures and forwards. However, between the two of them, there is one essential difference. Once you opt for an options contract, you are no longer obligated to act in accordance with the terms of the agreement. These contracts are quite similar to futures and forwards. However, there is one key difference. Once you buy an options contract, you are not obligated to hold the terms of the agreement. Even if you hold a contract to purchase a hundred shares by the expiration date, you will not be mandated to. Options contracts are traded publicly on stock exchanges.
Derivatives Trading Tips
Trading in the stock market or cash segment is very similar to trading derivatives.
- Firstly, you should ensure you conduct your own research. Remember that the strategies you use in the derivatives market need to vary from those used in the stock market. For example, if you wish to purchase stocks that are likely to see an increase in demand at some point in the future, you might wish to conduct a trade. On the derivatives segment, this will require you to enter a sell transaction. Hence, the strategy would vary.
- Make sure you arrange for the requisite margin amount. Stock market rules require that you constantly maintain your margin amount. Hence, at any point, you cannot withdraw this amount from your trading account until the moment your trade is settled. Remember that the margin amount changes as the price of the underlying stock falls or rises. For this reason, always be sure to keep extra funds available for trading in your account.
- The transaction for your trade should be conducted through your trading account. First, you will have to make sure that your account allows you to trade in derivatives. If this is not the case, consult with your brokerage, or stockbroker so you can get the required services activated. Once this is done, you can place an online order or place one through a phone call to your broker.
- Choose your stocks and their contracts based on the amount you have in hand, the underlying price, margin requirements, and the price of contracts. You will be required to pay a small amount so you can sign your contract. Choose to wait until the contract expires, so you can settle the trade. In this case, you are supposed to pay the entire amount outstanding. Alternatively, you can choose to enter into an opposing trade.
Derivatives trading, if done correctly, can easily be used to earn a living. However, seasoned derivatives traders conduct meaningful research, make careful market moves, hedge their bets, and follow their appetite for risk. Ensure you follow these basic principles when trading derivatives.