BAJAJ BROKING
February 20, 2025
9 mins read
In recent days, investing in the stock market has become an attractive option for individuals. There are several reasons behind the same. For example, it helps you build savings to secure your future finances, helps you invest systematically, and aids in wealth creation over time.
When it comes to investment in the stock market, investors and traders choose a variety of instruments to diversify their portfolios and enhance their returns. One such instrument is derivatives. Now, not to forget, there was a time when the derivatives market was a bit hard to decode owing to the complex financial terms and technology. However, that has changed very much in recent days. These days, traders can trade and invest seamlessly in the derivatives market thanks to the rise of new platforms and financial awareness.
Derivative trading has a lot to offer, starting from diversification to leverage, liquidity, and whatnot. Curious to learn more about derivatives trading? Well, then stay tuned and continue reading as we explore what a derivative is, the meaning of the derivatives market, its pros and cons, and much more in detail.
Before going any further, let's start with the basics. What is a derivative? Well, derivatives can be simply understood as financial agreements. Now, the value of these agreements or contracts very much depends on the underlying securities or assets. A derivative agreement is arranged between two or more parties and can be traded over the counter or on exchange.
The price of these derivatives fluctuates because of the fluctuations in the price of underlying assets. These derivatives come in handy to gauge market risk and are quite impactful in hedging.
Now that you have some basic understanding of derivatives let's see some common types of these derivatives.
Options Contract
The most basic yet important feature of an option contract is that it comes with rights where you may sell or buy the underlying securities over a preset period. However, there is no obligation to do the same. The sellers of these contracts are known as option writers, and the price at which they are sold is the strike price.
Option contracts are further classified into two types: call options and put options.
Futures Contract
Future contracts are legal arrangements where two parties agree on the sale or purchase of an underlying asset at a pre-set price over a predetermined period. What makes these futures contracts any different from options is that here traders are obligated to exchange before the expiry period.
The future contracts are of several types, including index futures, currency futures, etc.
Forwards
Forwards as well are financial arrangements between two parties. However, the basis of the contract is a preset price and quantity of the underlying assets to be traded before the expiry. Now, you also need to understand that, similar to futures, these forwards also come with an obligation.
Also, you need to execute these contracts on the over-the-counter or OTC derivative trading market.
Swap
Swaps are financial contracts where two parties agree to exchange their liabilities or financial obligations. This exchange of cash flow is done based on a predetermined formula. Also, just like forwards, the trading of such contracts can be done in the OTC market and not in the exchange market.
Now, before we jump to the advantages or disadvantages of derivatives trading, why not first understand what is derivatives trading.
Well, to put it in the most simple terms, derivative trading involves buying or selling derivatives, ones whose value comes from the underlying instrument. The best part about derivatives trading is that they allow you to buy a large amount with a small margin.
Here are some compelling advantages of derivative trading.
Hedge Risks
One of the most prominent benefits of derivatives trading is that they allow you to hedge risks. How, you ask? Say you bought a stock in exchange, and now you consider buying contrasting options in the derivatives market. Now, in case the value of your stock declines, this will ultimately lead to a rise in the value of your put options. Thus, reducing your overall risks.
Low Expenses
As derivatives are popular as risk-mitigating tools, the transaction costs of derivative markets and trading are comparatively lower than other instruments like equities, debentures, etc.
Transfer Risks
Another prominent advantage of derivatives trading is that risks here are transferable. This means traders, investors, or more may transfer their risks to other parties or shareholders. This also comes in handy in spreading and, thus, reducing the risk.
As mentioned, engaging in the derivatives market gives you quite some leverage. Plus, traders can buy large quantities even with small amounts. However, before you start engaging in the derivatives market, it's important you understand and be careful of some of the disadvantages of derivative trading.
High Risk
Derivatives are market-linked and as mentioned, their value is derived from underlying assets, like stocks. Now, when the underlying assets are volatile, with their prices fluctuating rapidly, the value of derivatives also fluctuates, making them highly risky. This may sometimes lead to big losses for traders.
Speculation
The basic design of derivatives is to speculate or you may say they are highly based on assumptions. Such speculations about price fluctuations, market movements, and more can go wrong sometimes leading to huge losses.
Counterparty Risk
Some derivatives, like futures, are traded on market exchanges like National Stock Exchange or Bombay Stock Exchange. However, there are derivatives, like forwards or swaps, that are OTC contracts. This means these are not regulated or standardized by any particular authority. Thus, opening the chances of payment defaults or other risks from the other party involved in the process.
Now that you have read about the advantages and disadvantages of derivatives let's quickly have a look at some popular uses of these derivatives.
Earn Money on Idle Shares
Let's say you have some idle shares with you. Now ,you plan to hold these for a long term. However, you also want to benefit from these shares. Here are derivatives which can help you earn from short-term fluctuations of such stocks. These allow you to make money and trade without the need to sell your shares.
Benefit from Arbitrage
You may also enjoy the benefits of arbitrage trading. Here, you may consider buying an asset at a comparatively lower price in a particular market and then selling it at a higher rate in another market. This helps you earn from the price differences between the two markets.
Protect Your Investments
One of the most prominent uses or advantages of derivatives is that it helps you financially secure your investments. You may use them to hedge in case you're speculating about price fluctuations of your shares or securities.
Transfer of Risk
As mentioned earlier, with derivatives you may also transfer your risk. Investors willing to reduce their risks use derivatives to transfer the same to individuals willing to make more profits.
As mentioned, derivatives have a variety of benefits to offer. However, different individuals or entities engage in the derivatives market with different motives. Here are some common participants engaged in derivatives trading.
Hedgers
Hedgers are participants who are engaged in the derivatives market with the motto of hedging or reducing their risk. Generally, these are producers of underlying securities or commodities like metal, oil, etc.
They ensure they can get a preset price for their goods even if the price of underlying securities falls during the expiry period. The financial contract of the derivatives helps hedgers with a particular strike price, helping them reduce their risks and losses.
Speculators
Speculators can simply be understood as someone who predict. These are traders who use a variety of tools, techniques, and market knowledge, to gauge market trends. Based on the same, they predict the future price changes of underlying assets and aim to benefit from the same.
For example, if a speculator predicts that the price of an underlying asset may go up, they may consider buying a financial contract and then selling the same before expiry to earn a profit.
Arbitrageurs
Arbitrageurs are traders who aim to earn benefits from price differences of the same underlying assets in two different markets. Their main reason for entering the derivatives market is to earn a better price using market imperfections.
Margin Traders
The crucial hunt for margin traders starts with identifying profitable stocks. Once done, they consider taking a margin from their brokers and using the same for sales and purchase of financial contracts. The goal is to earn profits from the movement of prices during a trading day.
If you've read up till here, you've already read about derivatives, their uses, advantages, disadvantages, market, etc. Now, let's explore deeper and understand how to trade in the derivatives market. Here is your step-by-step guide.
First, consider searching and then choosing a reputed lender for yourself. Now open an online trading and demat account to start with your futures and options contract.
Also, you must understand that you will need to have to pay a margin amount to your broker. This helps maintain your orders. In case your account falls below a certain margin, you are likely to get a margin call. This is a warning to rebalance your account.
Further, you may only trade in contracts that can be purchased/sold in the market. Also, you need to settle your contracts before the expiry period.
To give derivatives trading a go, make sure you fulfil all the prerequisites. As mentioned, start with having a demat and trading account of your own. Once done, make sure to have enough funds in your account to facilitate exchange in the share market. In most cases, this amount is equivalent to the margin required for your contract. Further, you may consider contacting your broker for more information on the derivatives market, derivative trading, minimum investment, and other information.
Derivative trading has a variety of benefits, starting from hedging to risk transfer and much more. However, you need to understand that to benefit from such trading, you need to have rigorous research and knowledge of the derivatives market, its trends, and much more. Also, they aren't completely risk-free.
Therefore, it is important to carefully engage in the derivatives market and trading. You may consider gaining more knowledge on financial tools, techniques, and expert advice to do and grow better.
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Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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The value of derivatives depends very much on the underlying assets. This means their volatility may fluctuate given if underlying assets are risky or volatile. However, with proper market research and knowledge, these may turn out to be low-risk instruments.
Futures are a type of derivatives. These contracts come with an obligation between two or more parties. In addition to futures, there are some other types of derivatives as well, including options, swaps, etc.
The main purpose of derivative trading differs for different participants. For example, for hedgers, the main goal might be to hedge risks, while for speculators, it might be to earn profits from predictable price movements.
Yes, like any other financial instruments, derivatives are also not risk-free. You might end up losing your money with derivative trading in case of bad speculation and certain other circumstances.
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