Derivatives Trading: Meaning, Types and Benefits

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. However, India has witnessed a massive 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, you must understand derivatives in detail.

Derivative Trading: What is it?

So, what are derivatives in the share market? 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 to Trade

Now that you know what are derivatives in the stock market, let’s discuss its types. Derivatives can be classified into the following types:

Futures

Futures contracts are standardised contracts to either purchase or sell an asset at an agreed-upon price at a specified future date. These contracts are listed on exchanges and are popular with traders and investors to hedge or speculate on price movements. Futures contracts are leveraged, which means a trader only puts up a margin and enables him or her to control a larger position with less capital. However, both sides are required to adhere to the contract by either accepting or executing delivery of the asset or by a cash settlement.

Options

An option gives the buyer the right, but not the obligation, to purchase or sell an asset at the agreed price during some specific time period. There are two option types — call options (which provide the right to purchase) and put options (which provide the right to sell). The option has a premium that is the maximum potential loss to the buyer.

If it doesn’t get exercised before the expiry date, the option becomes worthless. In contrast to futures, which obligate the buyer and seller to the transaction, options trading provides flexibility, as the buyer can let the option expire unexercised if it is not profitable.

Forward

These types of derivatives in stock market are similar to futures, wherein you agree to buy or sell an asset at a future date at a predetermined price. However, forwards are tailored and traded over-the-counter (OTC). They are privately negotiated between two parties, in contrast to futures. This provides much more flexibility but introduces counterparty risk since no exchange or clearing house guarantees the contract.

Swap

Swaps are deals between two parties to exchange cash flows according to a series of financial specifications. They are commonly employed for managing risk and can be tailor-made as per the individual’s requirements. Common types of swaps include:

Interest Rate Swaps: One party agrees to pay fixed interest payments while the other party pays floating rates, or vice versa. This insulates the company against exposure to interest rate risk.
Currency Swaps: It refers to the swapping of cash flows in one currency with those in another. This is needed for companies that work in more than one country or with different currencies.

Difference between a Futures and an Options Contract

There is one big difference between futures and options.

With options, the buyer or seller can choose to buy or sell the asset. They can also decide not to do anything if they don’t want to. They are not forced to act.

With futures, both the buyer and seller must follow the contract. They are legally bound to buy or sell the asset when the contract ends. They do not have a choice.

Parameter	Futures	Options
Definition	A contract to buy/sell an asset at a fixed price on a future date.	A contract giving the right (but not obligation) to buy/sell an asset.
Obligation	Buyer and seller are obligated to execute the contract.	Only the seller has an obligation; the buyer has a choice.
Risk Level	Higher risk due to mandatory execution.	Limited risk for the buyer (premium loss), higher for the seller.
Premium Payment	No premium; margin money is required.	The buyer pays a premium to the seller.
Profit Potential	Unlimited profit and loss for both buyer and seller.	Buyer has limited loss, unlimited gain; seller has limited gain.
Cost Involved	Requires margin and mark-to-market adjustments.	Buyer pays premium; no daily margin for buyer.
Execution	Must be settled on expiry unless squared off earlier.	Can choose to exercise or let it expire worthless.
Complexity	Relatively simpler to understand.	Slightly more complex due to option types (call/put) and strategies.
Use Case	Hedging and speculative trading.	Hedging, speculation, and income strategies.
Liquidity	Generally high, especially in index and major stock futures.	Varies across contracts; some options may be less liquid.

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 accounts, 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?

Because derivatives like futures and options take their value from underlying assets, they have the ability to influence the prices of such assets in the short run. For example, when the quantity of individuals who buy futures and call options with a specific stock as the underlying asset increases exponentially, it projects an optimistic outlook on the stock’s near-price. This generates additional demand and makes investors purchase additional shares of that stock in the cash segment, hence raising the stock prices.

Advantages of Derivatives Trading

Hedging: You can use derivatives to protect yourself from price changes. For example, a company can use futures to lock in raw material prices.
Leverage: You can control a large trade with less money. This can increase your profits.
Access to Many Assets: With derivatives, you can trade things like gold, oil, stocks, or currencies in one place.
High Liquidity: It’s easy to buy and sell derivatives quickly. You don’t have to wait long to find a buyer or seller.
Diversification: You can spread your investments using derivatives. This helps lower your overall risk.

Disadvantages of Derivatives Trading

Leverage Is Risky: While leverage can increase profits, it can also increase losses. A small price change can cause big losses.
Complicated to Understand: Derivatives are not simple. You need to know the market and the contract well.
Time Limit Risk: Most contracts have an end date. If your guess is wrong or too late, you could lose all your money.
Counterparty Risk: If trading OTC (not through an exchange), the other party may not fulfill their obligation.
Market Volatility: Derivatives can cause a big swing in price when a large trade occurs. This can make markets unstable.
High Costs: Additional charges, margin money, and penalties might be there. They will reduce your profit.

Who Participates in the Derivatives Market?

The derivatives market has different participants who play specific roles depending on their objectives and risk tolerance. These participants can be categorised broadly into seven categories, and their participation ensures overall liquidity and market efficiency.

Hedgers

These participants employ derivatives to mitigate the risk of price volatility. Farmers, exporters, and companies hedge against risks such as commodity price volatility or currency movements to ensure stability.

Speculators

Speculators seek profits from price changes. They bear greater risks by forecasting market directions using futures or options, providing essential liquidity to the market.

Arbitrageurs

They exploit price discrepancies between markets. They aid in equalising prices and making the market more efficient by selling high in one and buying low in another.

Institutional Investors

Pension funds, mutual funds, and hedge funds employ derivatives for the management of risk, diversification, and profit augmentation. Their substantial trades provide the market with depth.

Banks and Financial Institutions

They participate in both risk management and as intermediaries. Banks also offer derivatives to clients and help provide liquidity and stability.

Retail Traders

Individual investors trade in smaller volumes through brokers, mainly for speculation or hedging. Online platforms have made their participation more prominent.

Exchanges

Entities like NSE provide the platform for derivatives trading. They ensure trades are transparent, standardised, and settled properly.

Risks Involved in Derivative Trading

While derivatives provide a lot of potential, they also possess some risks that have to be understood by traders prior to entering the market.

Market action can run contrary to your position and result in losses.
Leverage can both amplify gains and losses.
Certain contracts might not have sufficient buyers or sellers and can be difficult to liquidate.
In some instances, the counterparty can default on its contract.
The complexity of derivatives can result in misinterpretation or error.
Emotional choices in a fast-paced setting can lead to negative results.

What is the Use of Derivative Trading?

Derivative trading in India, through instruments like futures and options, allows investors to meet different financial goals without directly buying or selling shares. Here is how it helps:

Earn on Idle Shares

If you are holding shares for the long term, derivatives allow you to make short-term profits without selling them. This is done through a process called physical settlement.

Arbitrage Opportunities

Derivatives let traders take advantage of price differences between markets by buying in one and selling in another. This strategy is known as arbitrage.

Investment Protection through Hedging

If you are worried about a price drop in the shares you own, derivatives can help you protect your investment. They can also be used to lock in prices if you plan to buy shares later.

Transfer of Risk

Derivatives help shift market risk from conservative investors to those willing to take more risk. This balance supports both cautious investors and active speculators, making risk management more efficient.

Conclusion

Derivative trading might sound tricky, but it is actually easy to begin. You don’t need any special tools or machines. All you need is a Demat account and a trading account in India. Once you have these, you can start buying and selling derivatives.

If you are new to trading, make sure to do some research first. Learn the basics and understand how the market works. This will help you avoid mistakes and manage your money better.

What is Derivative Trading?