In thi article, we will discuss
- What is Derivative?
- Types of Derivatives Market
- Benefits of Trading in the Derivatives Market
- Types of Derivatives Contract
Investors often utilise their hard-earned money to take risks in the stock market. However, when it comes to the derivatives market, it becomes crucial to know the tricks of the trade. This sole possibility of making high profits in the stock market is quite appealing, but an impulsive position can also lead to a loss of capital.
Read this blog to get a clearer understanding of derivative meaning in the stock market.
What is Derivative?
When a financial instrument does not have its own value, it derives its value from other financial securities. Hence, derivatives are financial contracts set between two parties, and they derive their value from another financial security, known as its underlying asset. These financial securities could be stocks, commodities, currencies, etc.
The value of a derivative depends upon price fluctuations in the value of its underlying asset. Some of the most common stock market derivatives are futures, options, forwards and swaps in India.
Types of Derivatives Market
There are primarily two ways to buy and sell derivatives in the share market today.
Exchange-traded (ETD) Derivatives Market
As its name suggests, this is a derivatives market regulated by an authority, which in India is the Securities and Exchange Board of India (SEBI). Derivatives in this market are bought and sold over an exchange by following all the rules established by SEBI. All derivatives traded via a stock exchange come with a preset strike price, expiry date, lot size and settlement procedure. Since they are uniformly regulated by an exchange, they carry a lower risk of default.
Over-the-Counter Exchange Derivatives Market
This is a non-regulated market where these contracts are negotiated privately between two parties. There is no involvement of an exchange or any regulatory body; hence, the terms and conditions of the contract can be modified mutually as per the needs of both parties. A lack of exchange also makes this market a lot riskier than ETD because the risk of default is significantly higher.
Benefits of Trading in the Derivatives Market
Hedging is a risk management strategy where a trader tries to mitigate the risk of loss by taking a counter position in that related asset. Derivatives are one of the best ways to hedge your open positions by taking an offset position and minimising your losses.
For example, you have bought an options contract for crude oil by predicting its price shall go up, but then you realise that it won’t. In this case, you can open another position to counter your loss and buy a derivative with a prediction that it will go down.
Arbitrage is the practice of buying a commodity or security for a significantly lower price in one market and then selling it for a higher price in the other market. Derivative markets allow a trader to pursue arbitrage in different financial securities.
Given the high volume of derivatives trading, it is a highly liquid market. Traders can easily square off their position if they ever find themselves in an adverse situation. However, this liquidity factor is more relevant in the case of ETD because the volume of trades is higher, and they are all uniform. Whereas in OTC derivatives, it can be difficult to liquidate your investments immediately.
Low Transaction Costs
Most traders enter the derivatives market to mitigate their risks. Hence, given the fact that it is a risk management tool, the transaction cost is significantly lower in derivatives as compared to other markets.
Types of Derivatives Contract
As discussed, there are four types of derivative contracts in India.
- Futures- This contract involves two parties who have agreed to buy and sell a contract at a specified date and price.
- Options- A contract where the option buyer has the choice to fulfil their agreement or not. In either case, the seller cannot force the agreement on them.
- Forwards - These are the types of contracts traded in over-the-counter exchange. They are custom-made future contracts.
- Swaps- As its name suggests, it is a contract to swap the cash flow between the two parties at a future date based on a predetermined formula. They are yet another OTC contract and not traded on exchanges.
Given the complexions and risks involved in the derivatives market, it is necessary that you enter it with caution. If you are still new to the securities market, take your time to understand different contracts and their pros and cons.
Learn the nuances of trading in its underlying securities to understand how it behaves and the risks associated with it. Some understanding of different chart patterns and analysis of the market can help you make more informed decisions. Exercising some diligence and caution will help you make the best out of your available opportunities and better utilise your capital.
Q1. What are the participants of a derivatives market?
Ans. The derivatives market has four primary participants involved. They are viz. hedgers, traders and speculators, arbitrageurs and margin traders.
Q2. What is the major difference between futures and options?
Ans. The future is a binding contract where the future buyer is liable to honour the terms of the agreement and buy/sell the specified underlying security at a predetermined price. Whereas in an options contract, the buyer has the right to exercise the agreement, but he is not liable for it. However, the decision of the option buyer is always binding on the seller.
Q3. What is one disadvantage of the derivatives market?
Ans. One major disadvantage of derivatives is that they are a highly risky financial instrument. Hence, recklessly trading in them can incur huge losses for you. It is best to always trade in them carefully.
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