What is Derivative Trading?

The financial market system in India can be broadly classified into two areas, namely the cash segment and the derivative segment. In the past few years, India has witnessed a huge surge in the turnover and trading volume of derivatives. This upsurge in turnover is nothing short of meteoric, as it has even managed to surpass the cash segment.

One of the main advantages of derivatives is that you don’t require any special tools or technologies to start trading in them. By opening a demat account and a trading account in India, you can get started with buying and selling derivatives. Here’s some more information on derivative trading and some key takeaways.

What is derivative trading?

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.

More information on derivatives

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.

Now that you know about derivatives, let’s take a look at some of the key things that you should know about derivative trading.

What are the prerequisites for trading in derivatives?

To get yourself started with trading in derivatives, you are required to satisfy three key prerequisites. Firstly, you need to possess an active demat account. Secondly, you’re also required to have a trading account in india. If you don’t already possess a trading account, you could get in touch with stockbroking firms like IIFL, who can help set up a trading account in India for you. You also need to link your trading account with your demat account. Thirdly, you are required to maintain a specific percentage of cash in your trading account in order to be able to trade in derivatives.

What is ‘margin money’ with respect to derivative trading?

Unlike the cash segment, derivative trading mandatorily requires you to hold a specific percentage of the value of your outstanding derivative position as cash in your trading account. This specific percentage is commonly referred to as ‘margin money’. You’re required to hold this margin money in order to help minimize the risk exposure for the stock exchanges you’re trading on.

Are any charges and taxes levied on derivative contracts?

Whenever you execute a trade in a derivative contract, you’re required to pay certain charges and taxes. Some of these are listed below.

  • Brokerage charges
  • Stock exchange transaction charges
  • Integrated Goods and Service Tax (IGST)
  • Securities Transaction Tax (STT)
  • SEBI turnover fees
  • Stamp duty

Do derivatives affect the prices of the underlying asset?

Since derivatives such as futures and options derive their value from underlying assets, they are capable of driving the prices of those assets in the short-term. For instance, when the number of people buying futures and call options of a particular stock rise exponentially, it paints an optimistic view on the near-term future of the stock. This creates more demand and triggers investors to buy more shares of that stock in the cash segment, thereby increasing the stock prices.

Conclusion :

Derivative trading is a complex yet interesting concept. While a trading account in India and a demat account is all that’s required to start trading, this segment is not for everybody. If you’re a beginner just starting out with trading in the markets, it is advisable to perform adequate research before venturing into the derivative segment.

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