What are derivatives?
Derivatives are contracts that derive their value from underlying assets. Such assets could be both physical (like a commodity) or financial (like a stock, index, currency or even an interest rate). Profits can be obtained by holding a derivative contract (e.g.: gold futures) as well as trading in the derivative contracts.
Types of derivatives
Forwards are over-the-counter (OTC) contracts or agreements between parties to exchange a particular quantity of an asset at a specific rate and on a given date. They help in hedging i.e. the risk of changing values of assets due to fluctuations in asset prices. However, forward markets do not have a central exchange for their operations. Therefore:
- They are highly illiquid (i.e. hard to find buyers or sellers randomly)
- They usually do not require any collateral and thus have counterparty risk i.e. risk of parties not following through an agreement
Futures are basically forwards but are traded on central exchanges like the BSE and NSE. Therefore, they have higher liquidity and lower counterparty risk than forward markets.
Options allow traders the right to buy/sell assets of a specific quantity at a specified price (called the ‘strike price’) on a specified date through a central exchange such as the BSE or NSE. The price charged for buying the contract is called the ‘premium’. Options are of two types:
- Call options – the buyer (said to go ‘long’ on the option) of the option gets the right to buy the asset from the seller (said to go ‘short’ on the option) at the given price.
- Put option – the buyer of the option gets the right to sell the asset to the seller of the option at the given price.
What is derivatives trading?
If you do not understand derivatives trading meaning then try using an example. Imagine a person who has bought a derivative contract, suppose a put option He may choose to hold that option until the date of exercise and then sell the requisite quantity of assets at the strike price. However, this is advisable only if that person is making a profit by executing the contract. For example, if the spot price of the asset is ₹1000 while the strike price of the option is ₹1200 then it makes sense for the person selling the asset to go through with the option contract as he can sell the asset at a higher price than the market rate.
However, if the spot price was approaching ₹1500, then holding the put option contract is not advisable at ₹1200 as the spot market may offer a higher rate. Now, the put option holder may choose to continue holding the contract and suffer the loss of the entire option premium, or he can sell the option contract at a premium (albeit a lower premium than what he paid to buy the put option) in the market to anyone still willing to buy the contract, thereby, reducing his losses.
Now, another trader may notice that the price of some other put option contract is increasing in price (i.e. the premium). She can thereby choose to speculate on the contract – buying it only to resale it at a higher premium.
Such buying and selling of derivatives are called derivatives trading. In this market, traders buy and sell derivatives based on the profitability of the contract – from the movement of both the price of the underlying asset in the spot market as well as the price of the contract itself (both of which are interlinked).
How to do derivatives trading?
You need the following three things to start trading in derivatives:
- A Demat account
- A Trading account that is linked to your Demat account
- The minimum amount of cash in a linked bank account that is needed to pay the margins required to invest in a derivative contract and/or execute it.
What is Margin in derivatives trading?
Trading in derivatives requires the trader to deposit a certain percentage of the total outstanding derivative position in the trading account as an assurance that the trader will follow through with the trade. It acts as a factor that reduces the risk exposure of both the stock exchange and the stockbroker – the latter may ask for only a percentage of the margin requirement and pay the rest of the requirement by furnishing a loan to the trader for that trade.
Charges and taxes on derivatives
- Brokerage charges
- Stock exchange transaction charges
- Integrated Goods and Services Tax (IGST)
- Securities Transaction Tax
- Stamp duty
Now that you know about the derivative market, you can start investing in the markets by opening a Demat account.