What is Derivative Trading?

What is Derivative Trading

The financial market system in India can be broadly classified into two areas; the cash segment and the derivative segment. The cash segment has always been an investor favourite of the investors. However, India has witnessed a huge surge in derivatives’ turnover and trading volume in the past few years.

This turnover surge is seen as unprecedented and meteoric, as it has even managed to surpass the volumes of the cash segment. Such investor interest has established derivatives as an ideal investment instrument that is more than worthy of being heavily profitable to investors. However, to invest in derivatives, it is vital that you understand derivatives in detail.

Derivative Trading: What is it?

Derivatives are essentially contracts that derive their value from an underlying asset. Derivative contracts are short-term financial instruments that come with a fixed expiry date. 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 market. With derivatives, you can make profits by predicting the future price movement of the underlying asset.

Types of Derivatives:

Derivative contracts can be classified into two types - futures and options. A futures contract 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, options 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. However, an options contract does not create an obligation on both parties to buy and sell the underlying asset. Furthermore, an option contract is sub-classified into two types - call option and put option.

Difference between a futures and options contract

There’s a key difference between a futures and an options contract. In the case of options, the buyer or the seller can either choose to exercise their right to buy or sell the underlying asset, or they could let the right lapse upon the expiry of the contract. With a futures contract, both the buyer and the seller are legally obligated to honour the contract upon expiry, and both parties must exercise the contract before expiry.

What are the prerequisites for trading in derivatives?

To get started with trading in derivatives, you are required to fulfil three key prerequisites:

  • Firstly, you need to possess an active demat account.
  • Secondly, you have to open a trading account in India. If you don’t already possess a trading account, you could get in touch with stockbroking firms like IIFL, which can help set up a free trading account in India for you. Once you set up both the Demat and trading account, you need to link both accounts.
  • Lastly, you are required to maintain a specific percentage of cash in your trading account to trade in derivatives. This amount is called margin money.

What is ‘margin money’ in derivatives trading?

Derivative trading requires you to keep a specific percentage of the value of your outstanding derivative position (total value of your holdings) as cash in your trading account. This specific percentage is commonly referred to as ‘margin money’. You are required to hold this margin money to help minimise the risk exposure for the stock exchanges you’re trading on. Furthermore, it works as a buffer to minimise losses for the stockbrokers who give you the remaining amount as a loan to buy the derivatives contract.

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)
  • 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 can drive the prices of those assets in the short term. For instance, when the number of people buying futures and call options with a particular stock as the underlying asset rises exponentially, it paints an optimistic view on the stock’s near-term price. 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. 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. If you’re a beginner and are just starting trading, it is advisable to perform adequate research before venturing into the derivative segment.