What are Derivatives?

What Is Derivative?

Derivatives are financial contracts that derive their value from an underlying asset such as stocks, commodities, currencies etc., and are set between two or more parties, where the value of the derivative is derived from price or value fluctuations of the underlying assets. Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or leverage holdings.

Derivative trading happens over the counter or via an exchange. Over-the-counter trading works between two private parties and is not regulated by a central authority. Furthermore, as two private parties agree on the contract, it is susceptible to counterparty risk. This risk refers to the possibility or rather the danger of one of the parties defaulting on the derivative contract.

Advantages Of Derivatives:

Here are the advantages of derivative trading:

1. Hedging

A derivative contract is the best way to protect yourself against a bad investment. When you trade-in derivatives in the stock market, you are essentially placing money on the possibility that a certain stock will either rise or fall in price. As a result, if you know that the stocks you have invested in are beginning to drop in value, you could enter into a derivative contract wherein you accurately predict the reduction in the stock value. Once the stock price starts falling, you can make profits in your derivatives contract by hedging your stock market losses.

2. Arbitrage

In Arbitrage trading, a commodity or security is purchased at a low price in one market and then sold at a significantly higher price in another market. Derivatives trading offers an advantage in terms of arbitrage trading to benefit from the differences in pricing in different markets.

3. Mitigating Market Volatility

Investing in derivatives enables you to remain protected from the volatility of other asset classes. For instance, you can buy stocks in the equities market and then enter into a derivatives contract with the same underlying asset. It can safeguard your portfolio health, as either of the investments can hedge your losses against the other.

4. Ideal investment avenue

While most traders enter into the derivatives market to speculate and profit, it is also an ideal way to invest any surplus funds you may have. Your funds will then generate additional profits without touching any of your existing, underlying securities.

Participants Of Derivatives Market:

Considering the high level of advantages available with derivatives trading, several different participants enter the derivatives market with their agenda. The definition of these participants changes based on their objective for derivatives trading:

1. Hedgers

They are the producers, manufacturers, etc., of the underlying asset and generally enter into a derivative contract to mitigate their risk exposure. Simply put, hedgers ensure that they will get a predetermined price for their assets and not incur a loss if the prices go down in the future.

For example, if you hold shares of a company, which are priced at Rs. 120, and you aim to sell these shares in 3 months; you’d ideally not want a fall in market prices to reduce the value of your investment. You also would not want to miss out on profits in case the market value goes up. By adopting a hedging position and paying a slight premium, you can ensure you are profitable if the stocks’ price falls or rises.

2. Speculators

These individuals are actual traders who try to predict the future price of commodities based on various factors and monitor their prices regularly. If these speculators think that the price of a particular asset will go up, they buy a derivatives contract of that asset and sell at the time of expiry to make a profit. For instance, in the above example, wherein you entered into a derivatives contract to protect yourself against the stocks falling, a speculator will bet that the stock price won’t fall. If in the determined period, the stock price does not fall, the speculator can make a profit.

3. Margin Traders

Margin traders are those investors who trade daily and make profits and losses depending entirely upon the day’s market movements. The margin here refers to the minimum amount paid to the broker by the investor to enter the derivatives market. These traders do not use their own money to buy and sell but borrow the amount as a margin from the stockbroker.

4. Arbitrageurs

Arbitrageurs are those traders who buy securities in one market at a lower price and then sell it for a higher price in another market. They can essentially turn a profit through the low-risk market imperfections.