What is Derivative Trading - Meaning, Types, Advantages

What is a Derivative?

Derivatives are financial contracts whose value is derived from the value of one or more underlying assets like shares, commodities, precious metals, currencies, etc. Since the value of underlying keeps on changing according to the market conditions, the corresponding value of their derivatives keeps changing as well.

The basic principle behind derivative trading is to earn profits by speculating on the value of the underlying asset on a future date. This future price can be affixed through the derivatives contract.

Types of Derivatives

Depending upon the conditions there are four major types of derivatives contracts:

Options

An option contract gives the buyer the right to buy/ sell the underlying assets during a certain period at a specified price. Here, the buyer of the contract is not under any obligation to exercise the option. Options contracts have an expiry date. In the Indian stock market, there are options contracts that expire on a weekly or monthly basis.

Future

Future are standardized contracts where two parties enter into a contract to buy/ sell the assets at an agreed price on the specified date i.e., “future delivery”. The value of the contract is marked to market every day, which means the profit or loss borne by the respective party is calculated and adjusted in their margin amount every day. Futures Contract also has an expiry date, and in the Indian stock market, Futures Contracts expire on monthly basis.

Forwards

Forward contracts are custom-made between two parties in which the settlement between the parties takes place in the future on any decided date. These are like future contracts where the holder is under an obligation to perform the contract. These are available Over The Counter (OTC) and are not marked to market, they carry more counterparty risk for both parties involved.

Swaps

Swap contracts allow the exchange of cash flows between two parties. It is a contractual agreement between two parties to exchange cash flows on a pre-planned formula at a future date. Swaps are not traded on exchanges and are OTC between business and financial institutions.

Additional Read: What is Demat Account

What is Derivative Trading?

Buying and selling of Derivatives contracts is known as Derivative Trading. In this, an investor can buy a large quantity of the underlying assets by just paying a small initial amount (margin). Through derivatives, you can trade in different assets, such as:

• Stocks
• Commodities
• Currencies

How to trade in the Derivatives market

To trade in the Derivative market below is the Prerequisites:

• You need to have a Demat and Trading Account
• Add sufficient funds to your Demat Account to buy and sell derivatives (The amount should meet the margin amount required for buying the contract)

Derivative trading advantages

• Hedge Risks: Derivative trading lets you hedge your position in the cash market since the value of the derivatives is linked to the value of the underlying assets. To hedge risks, an investor buys a derivative contract that compensates for the loss that may result due to market-moving in the opposite direction than expected.
• Higher Risk-Reward Ratio: Derivative Trading involves a higher risk compared to regular delivery trading of shares since derivate contracts are traded in lots and positions are highly leveraged. As a result, the corresponding risk associated is higher, also the returns are higher comparatively.
• Large Position Size: Since Derivative contracts are traded in lots, which can be bought by just paying the margin amount, it is possible to take a large position with smaller capital.

Additional Read: Demat Vs Trading Account
 

Derivative trading risks

• High Risk: Due to the leveraged position under a derivative contract, one can potentially incur huge losses.
• Speculative in nature: Derivatives are widely used as a tool of speculation. Due to the high risk and unpredictable behavior associated with them, it tends to be highly volatile at times which can lead to magnified losses.