What are Derivatives?

Derivatives are widely used to manage market risk, protect investments from price fluctuations, and take positions based on expected market movements. Their value is linked to underlying assets such as stocks, commodities, currencies, or indices. While derivatives can support risk management and trading strategies, they also involve market exposure and require proper knowledge before participation. 

Key Takeaways

What are Derivatives? 

Derivatives are financial contracts whose value is determined by an underlying asset, such as stock shares, indices, commodities, currencies, or interest rates.  

As per the Securities Contracts (Regulation) Act, 1956 (SCRA), derivatives include contracts derived from debt instruments, shares, loans, risk instruments, or contracts for differences, as well as derivatives based on securities, indices, or prices of underlying assets. Rather than trading the underlying asset directly, participants trade contracts based on its estimated price changes. 

Derivatives are mainly used for hedging risk, speculation, and arbitrage. Hedging helps investors protect themselves from potential losses caused by price fluctuations.  

For example, a farmer may use derivatives to lock in the future price of crops. Speculators use derivatives to earn profits by predicting market movements, while arbitrageurs exploit price differences in different markets. 

Although derivatives can provide opportunities for profit and risk management, they also involve high risk because their value can change rapidly. Therefore, investors need proper knowledge and understanding before trading in derivatives. 

How Derivatives Work 

To understand the derivatives meaning, it is important to know that these contracts derive their value from an underlying asset such as stocks, commodities, currencies, or market indices. When the price of the underlying asset changes, the value of the derivative also changes accordingly.  

Traders and investors use derivatives to hedge against possible losses, manage price uncertainty, or benefit from expected market movements. Since derivatives are linked to market performance, their gains and losses can change quickly, making market understanding and risk assessment extremely important. 

Types of Derivatives 

There are 4 main types of derivative contracts, such as futures, options, forwards, and swaps. 

Forwards 

Forwards are customised OTC contracts between two parties and are not traded on exchanges like NSE or BSE. In India, currency forward contracts fall under RBI regulation, while other OTC derivatives may be subject to SEBI oversight depending on the underlying asset and participant type. 

Over-the-counter Forwards are exposed to counterparty risk as well. Counterparty risk is a kind of credit risk in which the buyer or seller might not be able to keep their part of the obligation. If the buyer or seller becomes insolvent and is not able to deliver on their part of the bargain, the other party may not have any recourse to save their position. 

Futures

Futures are similar to forwards but differ in terms of standardisation and trading structure. Futures are standardised contracts where both parties are obligated to perform the contract. These financial contracts are traded on the stock exchanges. 

Options

These contracts grant the buyer the right to buy or sell the underlying asset at a predetermined price within a specified timeframe. The buyer has the choice to exercise this right, while the seller, referred to as the option writer, is obligated to fulfil the contract. If the buyer chooses not to exercise the contract, the maximum loss is usually limited to the premium paid. 

Swaps

These are a form of financial derivative commonly used to exchange one kind of cash flow with another. Swaps are not traded in exchanges but are private agreements between parties and are mostly traded over the counter. 

The most common types of swaps are currency swaps and interest rate swaps. For example, a trader may use an interest rate swap to change from a variable-interest loan to a fixed-interest loan or vice versa. 

Exchange-Traded vs OTC Derivatives 

Derivatives can be broadly classified based on where they are traded: 

Who Participates in the Derivatives Market? 

The derivatives market involves a wide range of participants, each with their own objectives and roles. Here are the key participants in the derivatives market: 

These are participants who use derivatives to protect themselves from potential price fluctuations in the underlying asset. Their primary goal is to reduce risk. For example, a farmer might use futures contracts to hedge against a drop in the price of the crops they will harvest in the future. 

These are individuals or entities who actively seek to profit from price movements in the derivatives market. They do not have an underlying exposure to the asset but take positions based on their expectations of future price changes. Speculators can include individual traders, hedge funds, and other financial institutions. 

These participants aim to exploit price differentials between related assets or markets. They buy low and sell high to profit from price inefficiencies. Arbitrageurs help maintain price consistency across different markets and are crucial for market efficiency. 

These traders deposit a minimum amount, known as a margin, with the broker to take part in the derivative market. Margins are adjusted daily through mark-to-market (MTM) settlement, reflecting gains and losses based on price movements.  

Margin trading offers leverage, allowing traders to control larger positions. For example, you bought 100 shares of XYZ Ltd for ₹1 lakh. In the derivatives market, the same capital allows you to take exposure to a larger contract value through leverage, without owning the underlying shares.  

How To Trade Derivatives? 

To trade in derivatives, investors are required to maintain margins as prescribed by the exchange. These typically include: 

If margins fall below required levels, investors must deposit additional funds (margin calls) to maintain their positions.  

Note: In India, stock derivatives are subject to physical settlement in many cases. This means that upon expiry, the underlying shares may need to be delivered (for sellers) or taken delivery of (for buyers), instead of just cash settlement. Index derivatives, however, are cash-settled. 

Steps To Trade in the Derivatives Market 

You need a trading account with a registered broker that provides derivatives access. 

Brokers may require suitability checks or additional approvals before allowing derivatives trading. 

Derivatives positions require upfront margin, usually including SPAN margin and exposure margin. 

Study price trends, volatility, news, and market conditions before placing a trade. 

Select the right futures or options contract based on your view, expiry, strike price, and risk appetite. 

Enter the order through your broker’s platform and confirm the quantity, price, and contract details. 

Track margins, price movement, and expiry closely, and use stop-loss or exit rules when needed. 

Close the position before expiry or allow it to expire/settle according to the contract type and exchange rules. 

Advantages of Derivatives

Hedging involves reducing investment risk by taking an additional position through derivative contracts. Derivatives are used with the objective of minimising risk in the market. 

Derivatives allow traders to take larger positions with a relatively lower upfront margin compared to the full value of the underlying asset. However, transaction costs such as brokerage, Securities Transaction Tax (STT), exchange fees, and margin requirements can impact overall profitability. 

Disadvantages of Derivatives

Derivatives are commonly used for speculation based on expected market movements. The unpredictable nature of the market makes speculation highly risky and may result in huge losses. 

As per SEBI and exchange data, a significant majority of individual traders in the equity derivatives segment incur losses. According to SEBI’s study, over 90% of individual F&O traders made net losses in recent years.