What is Derivative Trading: Types, Advantages, and Risks

Derivative trading is emerging as a powerful tool, offering investors a strategic way to buy and sell assets for future dates. These formal financial contracts, with fixed and predetermined expiry dates, present a compelling alternative to traditional asset acquisition. The appeal of derivative trading in the share market lies in its ability to significantly increase gains, making it an attractive choice over directly purchasing underlying assets.

This form of trading allows investors to control substantial quantities of assets with relatively minimal upfront capital. The versatility of derivative trading extends across various asset classes, including stocks, commodities, currencies, and benchmarks.

Derivatives trading is a complex subject, and it is essential to understand the underlying assets and the terms of the contract before investing in them.

What is a derivative contract?

A derivative contract is a financial contract that derives its value from an underlying asset, group of assets, or benchmark. The value of the contract is dependent on the performance of the underlying asset, such as interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivatives can be traded on an exchange or over-the-counter (OTC) between two or more parties. These contracts can be used to trade any number of assets and carry their own risks. Common derivatives include futures contracts, forwards, options, and swaps.

What is derivatives trading and how does it work?

Derivatives trading is a sophisticated financial practice that involves the buying and selling of contracts, known as derivatives, whose value is derived from an underlying asset.

Here's a breakdown of the key components and processes involved:

1. Choosing a registered broker: To engage in derivatives trading, individuals must first open a trading account with a registered broker affiliated with the specific exchange where the derivative contracts are traded. This ensures compliance with regulatory standards and provides access to a secure trading platform.
2. Placing an order: Once the trading account is set up, investors can place orders to buy or sell derivative contracts through their chosen broker. These orders are submitted to the exchange, where they are matched with corresponding orders from other market participants.
3. Execution on the exchange: The actual execution of the derivative contract takes place on the exchange. This ensures transparency and fair pricing as the market dictates the contract's value. Exchanges in India, such as the National Stock Exchange (NSE) and Bombay Stock Exchange (BSE), are prominent venues for derivatives trading.
4. Initial margin requirement: One distinctive feature of derivatives trading is the need for an initial margin. Before executing a trade, investors are required to deposit a percentage of the total contract value as an initial margin. This acts as a security deposit, ensuring that traders have the financial capacity to fulfil their contractual obligations.

Types of derivative contracts

Let us explore some of the most common types of derivative contracts.

1. Options contracts

Overview: Options contracts grant the holder the right (but not the obligation) to buy or sell an asset at a predetermined price and date in the future.

Characteristics:

• Flexibility: Option holders have the freedom to choose whether to execute the trade or not, depending on market conditions.
• Risk management: Investors use options to hedge against potential losses or to predict future price movements.
• Versatility: Options can be applied to various assets, including stocks, commodities, and currencies.

2. Futures contracts

Overview: Think of futures contracts as standardised agreements between two parties to buy or sell an asset at a predetermined price and date in the future.

Characteristics:

• Standardisation: Futures contracts follow a set structure, including contract size and expiration date, making them easily tradable on exchanges.
• Risk mitigation: Investors use futures to protect against price fluctuations, providing a form of insurance for their assets.
• Liquidity: Being exchange-traded, futures contracts offer high liquidity and efficient price discovery.

3. Forwards

Overview: Forwards are customised transactions directly between two parties, tailored to their specific needs.

Characteristics:

• Tailor-made: Forwards allow parties to craft agreements with unique terms, offering more flexibility than their exchange-traded counterparts.
• Private arrangements: Since forwards skip the exchange setting, transactions remain confidential between the involved parties.
• Diverse applications: From commodities to interest rates, forwards find applications in a wide array of assets.

4. Swaps

Overview: Swaps adapt to the needs of parties by exchanging cash flows based on different financial instruments.

Characteristics:

• Cash flow exchange: Swaps involve swapping cash flows, with interest rate swaps and currency swaps being the most common variations.
• Risk management: Parties use swaps to manage and optimise their exposure to various financial risks.
• Customisable: Swaps are versatile tools, allowing parties to tailor agreements to their specific financial circumstances.

Advantages of derivatives trading

1. Risk management:

• Advantage: Derivatives act as powerful risk management tools, allowing investors to hedge against price fluctuations and uncertainties.
• Example: A farmer may use futures contracts to protect against the volatility of crop prices, ensuring a stable income.

2. Leverage:

• Advantage: Derivatives enable investors to control larger positions with a relatively small upfront investment, magnifying potential returns.
• Example: An investor using options can achieve significant gains with a fraction of the capital required to buy the underlying asset.

3. Price discovery:

• Advantage: The trading of derivatives contributes to efficient price discovery in the market, reflecting the collective expectations of participants.
• Example: Futures contracts, being exchange-traded, provide real-time information about asset prices, aiding in market transparency.

4. Diversification:

• Advantage: Derivatives offer a diversified investment portfolio by allowing exposure to various asset classes, reducing overall risk.
• Example: An investor may use commodity derivatives to diversify a portfolio heavily concentrated in equities.

5. Efficiency in markets:

• Advantage: Derivatives trading enhances market efficiency by facilitating the flow of capital and ensuring liquidity.
• Example: Options and futures contracts provide liquidity, allowing for seamless buying and selling activities.

Disadvantages of derivatives trading

1. Complexity and understanding:

• Disadvantage: Derivatives can be complex, requiring a thorough understanding. Misjudgments may lead to financial losses.
• Caution: Investors should educate themselves and seek professional advice before venturing into derivatives trading.

2. Leverage risk:

• Disadvantage: While leverage can amplify gains, it also increases the potential for significant losses, especially in volatile markets.
• Caution: Investors should be cautious about the level of leverage employed and its correlation with risk tolerance.

3. Counterparty risk:

• Disadvantage: OTC derivatives expose investors to counterparty risk, as these transactions lack the oversight provided by exchanges.
• Caution: Thorough due diligence is essential when engaging in OTC transactions to assess the financial stability of the counterparties involved.

4. Market risk:

• Disadvantage: Derivatives are inherently tied to market movements, and adverse changes can result in financial setbacks.
• Caution: Investors should regularly assess market conditions and adjust their derivative positions accordingly.

5. Regulatory risks:

• Disadvantage: Evolving regulatory landscapes may impact derivatives markets, introducing uncertainties and compliance challenges.
• Caution: Staying informed about regulatory changes and adapting strategies accordingly is vital for navigating this risk.

Who participates in the derivatives market?

Understanding the roles of key participants sheds light on the multifaceted nature of derivatives trading.

1. Hedgers: Hedgers are risk-averse participants in the derivatives market who utilise derivative instruments to protect themselves from adverse price movements in the underlying assets. These individuals or entities already possess exposure to the underlying asset in their portfolios, and they use derivatives to hedge against potential losses.
2. Arbitrageurs: Arbitrageurs are participants in the derivatives market who capitalise on price differentials between related assets or markets. Their goal is to exploit inefficiencies and imbalances to make risk-free profits. Arbitrageurs continuously monitor the market for pricing anomalies and execute trades to benefit from these disparities.
3. Margin traders: Margin traders, also known as speculators, actively participate in the derivatives market with the primary aim of capitalising on price movements for profit. Unlike hedgers, margin traders do not have an inherent exposure to the underlying asset. Instead, they seek to take advantage of market fluctuations by buying low and selling high.

How to trade in the derivatives market

Now that we have grasped the essence of derivatives, let us navigate the practical steps involved in trading these financial contracts for effective diversification and enhanced profits.

1. Choose a stockbroking firm and create an online trading account

• Action: To kickstart your journey into derivatives trading, select a reputable stockbroker and set up an online trading account.
• Rationale: This account serves as your gateway to the derivatives market, allowing you to engage in various financial contracts.

2. Open a Demat account and activate F&O service

• Action: Within your chosen stockbroking platform, open a Demat account. Additionally, request your stockbroker to enable the futures and options (F&O) service.
• Rationale: The Demat account not only facilitates regular trading but also extends its services to include trading in F&O contracts, broadening your investment horizons.

3. Maintain the margin amount

• Action: Upon initiating trades, your broker will require you to deposit a margin amount, a sum that must be maintained until the contract is executed or exited.
• Rationale: This margin acts as a security, ensuring you have the necessary funds to honour your commitments in the derivatives market. Falling below the required margin triggers a margin call, prompting you to rebalance your trading account.

4. Understand contract expiry dates

• Action: Recognise that financial contracts in the derivatives market typically have a three-month lifespan, concluding on the last Thursday of the month.
• Rationale: Being aware of the expiry date is crucial, as failing to settle the contract by this date may result in an auto-settlement on the expiry day. This knowledge is integral to managing and planning your trading activities effectively.

5. Execution and settlement

• Action: Execute your trades within the stipulated timeframe and settle the contract by the agreed-upon expiry date.
• Rationale: Timely execution and settlement are imperative to ensure the smooth flow of transactions and prevent any unforeseen consequences associated with missed deadlines.

Conclusion

Derivatives trading offers numerous opportunities, but it is not without its pitfalls. While the advantages include risk management, leverage, price discovery, diversification, and market efficiency, investors must navigate the complexity, leverage risks, counterparty risks, market risks, and regulatory risks. As you continue your exploration of derivatives, a nuanced understanding of these pros and cons will allow you to exercise these financial instruments wisely in their pursuit of financial goals.