Derivatives : Meaning, participants, types and more

Derivatives are contracts that derive their value from the underlying asset. These are widely used to speculate and make money. Some use them as risk transfer vehicle as well. This article covers what are derivatives, who uses derivatives, types and steps to trade in derivatives.

What is a derivative?

Derivatives are financial contracts whose value is dependent on an underlying asset or group of assets. The commonly used assets are stocks, bonds, currencies, commodities and market indices. The value of the underlying assets keeps changing according to market conditions. The basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in future.

Imagine that the market price of an equity share may go up or down. You may suffer a loss owing to a fall in the stock value. In this situation, you may enter a derivative contract either to make gains by placing an accurate bet. Or simply cushion yourself from the losses in the spot market where the stock is being traded.

Why do investors enter derivative contracts?

Apart from making profits, there are various other reasons behind the use of derivative contracts. Some of them are as follows:

Arbitrage advantage:

Arbitrage trading involves buying a commodity or security at a low price in one market and selling it at a high price in the other market. In this way, you are benefited by the differences in prices of the commodity in the two different markets.

Protection against market volatility: 

A price fluctuation of an asset may increase your probability of losses. You can look for products in the derivatives market which will help you to shield yourself against a reduction in the price of stocks that you own. Additionally, you may buy products to safeguard against a price rise in the case of stocks that you are planning to buy.

Park surplus funds: 

Some individuals use derivatives as a means of transferring risk. However, others use it for speculation and making profits. Here, you can take advantage of the price fluctuations without actually selling the underlying shares.

Who participates in derivatives market?

Each type of individual will have an objective to participate in the derivative market. You can divide them into the following categories based on their trading motives:

Hedgers: 

These are risk-averse traders in stock markets. They aim at derivative markets to secure their investment portfolio against the market risk and price movements. They do this by assuming an opposite position in the derivatives market. In this manner, they transfer the risk of loss to those others who are ready to take it. In return for the hedging available, they need to pay a premium to the risk-taker. Imagine that you hold 100 shares of XYZ company which are currently priced at Rs. 120. Your aim is to sell these shares after three months. 

However, you don’t want to make losses due to a fall in market price. At the same time, you don’t want to lose an opportunity to earn profits by selling them at a higher price in future. In this situation, you can buy a put option by paying a nominal premium that will take care of both the above requirements.

Speculators: 

These are risk-takers of the derivative market. They want to embrace risk in order to earn profits. They have a completely opposite point of view as compared to the hedgers. This difference of opinion helps them to make huge profits if the bets turn correct. In the above example, you bought a put option to secure yourself from a fall in stock prices. 

Your counterparty i.e. the speculator will bet that the stock price won’t fall. If the stock prices don’t fall, then you won’t exercise your put option. Hence, the speculator keeps the premium and makes a profit.

Margin traders: 

A margin refers to the minimum amount that you need to deposit with the broker to participate in the derivative market. It is used to reflect your losses and gains on a daily basis as per market movements. It enables to get leverage in derivative trades and maintain a large outstanding position. Imagine that with a sum of Rs. 2 lakh you buy 200 shares of ABC Ltd. of Rs 1000 each in the stock market. 

However, in the derivative market, you can own a three times bigger position i.e. Rs 6 lakh with the same amount. A slight price change will lead to bigger gains/losses in the derivative market as compared to the stock market.

Arbitrageurs: 

These utilize the low-risk market imperfections to make profits. They simultaneously buy low-priced securities in one market and sell them at a higher price in another market. This can happen only when the same security is quoted at different prices in different markets. Suppose an equity share is quoted at Rs 1000 in the stock market and at Rs 105 in the futures market. 

An arbitrageur would buy the stock at Rs 1000 in the stock market and sell it at Rs 1050 in the futures market. In this process, he/she earns a low-risk profit of Rs 50.

What Are The Different Types Of Derivative Contracts?

The four major types of derivative contracts are options, forwards, futures and swaps.

Options: 

Options are derivative contracts that give the buyer a right to buy/sell the underlying asset at the specified price during a certain period of time. The buyer is not under any obligation to exercise the option. 

The option seller is known as the option writer. The specified price is known as the strike price. You can exercise American options at any time before the expiry of the option period. European options, however, can be exercised only on the date of the expiration date.

Futures: 

Futures are standardised contracts that allow the holder to buy/sell the asset at an agreed price at the specified date. The parties to the futures contract are under an obligation to perform the contract. These contracts are traded on the stock exchange. 

The value of future contracts is marked to market every day. It means that the contract value is adjusted according to market movements till the expiration date.

Forwards:

Forwards are like futures contracts wherein the holder is under an obligation to perform the contract. But forwards are unstandardised and not traded on stock exchanges. These are available over-the-counter and are not marked-to-market. These can be customised to suit the requirements of the parties to the contract.

Swaps: 

Swaps are derivative contracts wherein two parties exchange their financial obligations. The cash flows are based on a notional principal amount agreed between both parties without exchange of principal. The amount of cash flows is based on a rate of interest. One cash flow is generally fixed and the other changes on the basis of a benchmark interest rate. 

Interest rate swaps are the most commonly used category. Swaps are not traded on stock exchanges and are over-the-counter contracts between businesses or financial institutions.

Pros and Cons of Derivatives

Pros:

• Risk Management: Derivatives allow hedging against price fluctuations in assets like commodities, currencies, or interest rates, reducing financial uncertainty.
• Leverage: They enable investors to control large positions with minimal capital, amplifying potential returns.
• Price Discovery: Derivatives markets reflect future price expectations, aiding in efficient pricing of underlying assets.
• Flexibility: Offer diverse strategies (e.g., options, futures, swaps) to suit various investment goals.
• Market Efficiency: Facilitate arbitrage opportunities, aligning prices across markets.

Cons:

• Complexity: Derivatives can be difficult to understand, increasing the chance of misinformed decisions.
• High Risk: Leverage can magnify losses as well as gains, potentially leading to significant financial damage.
• Counterparty Risk: Default by one party in over-the-counter (OTC) derivatives can lead to losses.
• Market Volatility: Speculative trading in derivatives can amplify price swings in underlying assets.
• Regulatory Challenges: Less-regulated OTC markets may expose investors to fraud or manipulation.

Risks of Derivatives

• Market Risk: Price movements in the underlying asset can lead to substantial losses, especially in leveraged positions.
• Credit Risk: In OTC derivatives, the risk of a counterparty failing to fulfill obligations can result in defaults.
• Liquidity Risk: Some derivatives may be hard to sell or exit without incurring significant losses, especially in illiquid markets.
• Operational Risk: Errors in trade execution, settlement, or mismanagement of derivative contracts can lead to financial losses.
• Systemic Risk: Interconnected derivative markets can propagate losses across financial systems, as seen in the 2008 financial crisis.
• Legal Risk: Ambiguities in contracts or regulatory changes can lead to disputes or unenforceable agreements.

How To Trade In Derivatives Market?

You need to understand the functioning of derivatives markets before trading. The strategies applicable in derivatives are completely different from that of the stock market.

The derivative market requires you to deposit a margin amount before starting trading. The margin amount cannot be withdrawn until the trade is settled. Moreover, you need to replenish the amount when it falls below the minimum level.

You should have an active trading account that permits derivative trading. If you are using the services of a broker, then you can place orders online or on the phone.

For the selection of stocks, you have to consider factors like cash in hand, the margin requirements, the price of the contract and that of the underlying shares. Make sure that everything is as per your budget.
You can choose to stay invested till the expiry to settle the trade. In this scenario, either pay the entire outstanding amount or enter into an opposing trade.

Conclusion

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