Delving into the intricate world of financial markets involves understanding various types of derivatives in trading. These sophisticated instruments, including options, futures, swaps, and forwards, play a pivotal role in shaping investment strategies. Each derivative type carries unique characteristics, offering investors diverse avenues for risk management, speculation, and portfolio diversification. Let’s know more about them.
Table of Contents
Defining Derivatives
Derivatives are financial contracts that derive their value from underlying financial securities. In simple words, the value of derivatives contracts depends on the value of an underlying asset like a stock, a currency, a commodity, or an index. So, every derivative type has a unique relationship with the price of its underlying asset. For example, the derivative contract may increase in value if the underlying asset increases in value. It’s worth noting that the change in the value of the derivative may not necessarily be the same as that of the underlying asset.
Purpose of Derivatives
Most people open demat accounts because they look forward to investing in stocks and growing their money. However, investing or trading in the stock market is not easy, as it takes plenty of research to find the right stocks. Secondly, despite your efforts, you can still lose money due to factors like market volatility and market shocks. This is where financial instruments like derivatives can help you—they protect your investments from market volatility. You can use derivatives to hedge your existing trades/investments or speculate on the price of financial securities.
Types of Derivatives in India
Futures Contracts
- A futures contract is a standardised agreement to buy or sell a specific security at a predetermined price on a future date.
- As they are standardised contracts, they list and trade on stock exchanges like the NSE (National Stock Exchange) and BSE (Bombay Stock Exchange).
- The size of the contract, called the lot size, which is the number of assets bound to the contract, is fixed and regulated by the stock exchange.
- The future date is also known as the expiry date. On the expiry date, as per the agreement, a buyer holding the contract is obliged to buy the underlying assets. Likewise, a seller holding the contract on expiry is obliged to sell and deliver the underlying assets to the buyer. While asset classes like equity involve stock deliveries, in asset classes like commodities, the contract is settled in cash.
Options Contracts
- Like futures, options, too, are standardised contracts where the underlying securities are transacted on a future date at a predetermined price. So, like futures, options also have an expiry date and lot size and are traded on the exchange.
- However, in the case of an option, the options buyer has the privilege to decide whether or not they’d like to transact the underlying assets once the contract expires. However, the seller, on the other hand, has no such privileges. They are obliged to transact the underlying assets if the options buyer asks for them.
- Unlike futures contracts, there are two types of options contracts: call options and put options. Buying a call option contract gives you the right to buy the underlying assets at a predetermined price. Buying put options, on the other hand, gives you the right to sell the underlying assets at a mutually agreed-upon price. If you are a call option buyer, you benefit from upward price movements. In contrast, the asset’s falling prices profit a put option buyer.
- To purchase an options contract, the buyer pays a fee called the premium. Manage your risk effectively with our options trading platform that provides real-time market data and analysis.
Forwards Contracts
- Forwards contracts entail an agreement between two parties to buy and sell an underlying asset at a predetermined price on a future date.
- Unlike futures, forwards are not standardised contracts, or, in other words, they are not subject to regulation by an exchange and are not traded on an exchange.
Instead, forward contracts are self-regulated, customised and traded over the counter, which is why you can’t trade forward contracts using your trading account. - A forwards contract is also settled on its expiry. However, since they are not standardised, the counterparty risk, also called default risk, is higher in forwards compared to futures.
Swap Contracts
- These contracts are considered the most complex type of derivative instrument.
- Here, the two parties agree to swap or exchange a form of cash flow for another type of cash flow at a future date at a predetermined price. In other words, they agree to swap their financial liabilities.
- There are several types of swap contracts. The most commonly traded swaps are interest rate swaps and currency swaps. Interest rate swaps involve exchanging fixed and variable interest rates, while currency swaps entail trading or exchanging currencies between two parties.
- These contracts are not traded over an exchange but are privately traded, and arranged by investment bankers.
Trading Process in the Derivatives Market
As a retail investor, you are likely to trade the standardised types of derivatives, i.e., futures and options, since they are traded over the exchange.
- To partake in the F&O segment, you open a trading account with a broker like Share India and opt for the derivatives segment.
- Then, you start trading in the derivative market with a few clicks on your smartphone using your trading app.
- It’s important to note that derivatives trading involves high risks, and a lack of due diligence on your part can wipe out your capital in no time. So, it’s better to study each derivative type in more detail; understand everything about how the contract works.
Conclusion
In conclusion, understanding the various types of derivatives in trading, including options, futures, swaps, and forwards, is essential for investors navigating the complexities of financial markets. Each derivative type offers unique opportunities for risk management, speculation, and portfolio diversification. Armed with this knowledge, traders can make informed decisions, optimising their strategies in the ever-evolving landscape of the financial markets.
