Financial derivatives have changed the finance world by creating innovative ways to comprehend, measure, and manage risks. Derivatives are meant to facilitate the hedging of price risks of inventory holdings or a financial/commercial transaction over a certain period. By locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors and, thereby, serve as risk management instruments. The derivative market was introduced in India in 2000, and since then, it has gained great significance like its counterpart abroad.
“ Derivatives are financial securities and contracts that obtain value from something else, known as underlying securities. Underlying securities may be stocks, currency, commodities, bonds, etc.”
By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets,
increasing market liquidity and efficiency and facilitating trade and finance flow.
Derivatives can be used for several purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation/trading, or accessing otherwise hard-to-trade assets or markets. Some more common derivatives include forwards, futures, options, swaps, and variations such as synthetic collateralized debt obligations and credit default swaps.
Derivatives can either be exchange-traded or traded over the counter (OTC)
Exchange refers to the formally established stock exchange wherein securities are traded and they have a defined set of rules for the participants. Whereas OTC is a dealer oriented market of securities, which is an unorganized market where trading happens by way of phone, emails, etc.
Why should you invest in the Derivatives Market?
A derivative product can be structured to enable a pay-off and make good some or all losses if gold prices go up as feared.
Trading in the Derivatives Market
If you are new to Derivatives and have prior knowledge of the stock market, follow these simple steps before you start trading in derivatives. Hence, you can also join the share market training in Indore for proper guidance in the stock market under the well-experienced faculty, including the derivatives market.
Note: Trading in the derivatives market is very similar to trading in the cash segment of the stock markets. This has 3 key prerequisites –
What are the Types Of Derivatives?
The main instruments for derivatives trading in India are futures contracts, options contracts, swaps, etc. These instruments are originally meant for hedging purposes. However, their use for speculation can't be ruled out.
A forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at an amount agreed upon today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.
Example :
Suppose you must buy some gold ornaments, say from a local jewellery manufacturer, XYZ Gold Inc. Further, assume you need these gold ornaments some three months later, in December. You agree to buy the gold ornaments at INR 54000 per 10 grams on 15 March 2020. The current price, however, is INR 53600 per gram.
This will be the forward rate or the delivery price from XYZ Gold Inc. four months from now on the delivery date.
This illustrates a forward contract. Please note that there is no money transaction between you and XYZ Gold Inc. during the agreement. Thus, no monetary transaction takes place during the creation of the forward contract. The profit or loss to XYZ Gold Inc. depends rather on the spot price on the delivery date.
Now assume that the spot price on delivery day becomes INR 54100 per 10 grams. In this situation, XYZ Gold Inc. will lose INR 100 per 10 grams, and you will benefit the same on your forward contract. Thus, the difference between the spot and forward prices on the delivery day is the profit/loss to the buyer/seller.
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Future Contract |
Forward Contract |
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Traded on Organized Stock Exchange |
Over the Counter (OTC) in nature |
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Standardized contract terms, hence more liquid |
Customized contract terms, hence less liquid |
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Required margin payments |
No margin payments |
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Follow Daily Settlement |
Settlement happens at the end of the period |
Along with some exceptions to forward contracts, there are future contracts. What makes future different forward contracts is that we trade futures on stock exchanges while forward on the OTC market. OTC, or the over-the-counter market, is a marketplace for typically forward contracts.
An option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfil the transaction, that is, to sell or buy if the buyer (owner) & exercises the option. The buyer pays a premium to the seller for this right. An option that conveys to the owner the right to buy something at a certain price is a "call option"; an option that conveys the right of the owner to sell something at a certain price is a "put option."
Example:
Consider the same example. Let us now suppose that the seller, XYZ Gold Inc., believes that the spot price may rise above INR 54000 per 10 grams during your forward contract agreement. So, to limit loss, XYZ Gold Inc. purchases a call option for Rs. 1050 at the exercise price of INR 54000 per 10 grams with a three-month expiration date.
The exercise price is technically known as a strike price. Similarly, the price of the call option is technically known as the option price or the premium.
The call option gives the buyer the right to buy the gold at the strike price on the expiration date. However, there is no obligation to buy on the expiration date. He may or may not exercise his right on the expiration date. If the price is in the buyer's favour, he will exercise his rights and receive the intrinsic value from the writer of the option.
For instance, if the spot price declines below INR 53600, XYZ Gold Inc. will choose not to exercise the option. In this way, his loss would be limited to the premium of INR 1050 per 10 grams.
In an alternative situation, when you expect the price to fall below the spot price in the future, you have the option to purchase put options. Buying a put option provides you with the advantage of selling at the strike price on the expiration date. Here also you have no obligation to exercise your right.
The swap contract involves an exchange of cash flows over time. Swaps are typically done between two parties. One party makes a payment to the other. This depends on whether a price is above or below a reference price. This reference price is the basis of the swap contract, and there is a mention regarding it in the contract.
Some Rules of investing/trading in the Derivatives market
Who are the participants in derivatives markets?
This investor buys an asset at a cheaper rate from one market and sells it at a higher price in another market, where the investor takes the minimum risk. This price gap is brief and narrows down quickly, and the arbitrageurs might lose the opportunity.
Hedging is minimizing risk or loss. An investor who protects his investment from unfavourable price movements is called a hedger in the market. A hedger tries to limit risk by buying put options and paying a fixed amount known as premiums.
They are the risk-takers. They take high risks, expecting higher gains in the short term. They buy stocks expecting a price rise and sell them at a high price level. This situation can make high gains for an investor, but it also has a high risk of losing money.
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