A derivative is a legal financial agreement that enables a buyer and seller to exchange money for an asset at a later time. The termination date of a derivative contract is fixed and predetermined. In the stock market, trading derivatives is preferred to purchasing the underlying asset because gains can be artificially inflated.
Additionally, since derivative trading is a leveraged form of trading, you can purchase a significant amount of the underlying assets for a relatively low cost. The trading of stocks, commodities, currencies, benchmarks, and other derivatives is possible.
The two main categories of derivative contracts are futures and options. Since both the investor and the seller project the price of the underlying asset for a specific future date, both are essentially the same. But futures and options are different because in a futures contract, both the buyer and the seller are required by law to fulfill their obligations when the contract expires.
But with options, the buyer or seller can either buy/sell before the contract expires by using their rights or they can wait for the contract to expire without using any of their rights. Call options and put options are the two categories of options. When they think the value of the underlying asset will increase, investors buy a call option. In contrast, they buy a Put option when they are certain that the price of the underlying asset will decrease.
Types of Derivatives
Financial contracts known as derivatives, which are made between two parties, derive their value from an underlying asset like stocks, currencies, commodities, and so forth. Such instruments are widely used by organizations in India to leverage holdings, hedge positions, and speculate on the price movement of the underlying asset. Four different asset types are traded on the derivatives market.
- Options Contract
Depending on the type of options contract, the buyer has the right but not the obligation to buy or sell the underlying securities to a different investor over a predetermined period. The strike price is the security price in the options contract, and the seller of the contract is known as the option’s writer.
The buyer in an options contract has the choice to forego exercising the right because they are not obligated to do so after paying the premium to the writer of the option. Call options and put options are the two categories into which options contracts are divided.
- Futures Contract
In the derivatives sense, a futures contract obligates both parties to carry out the agreement within the given time frame. Both the quantity of the underlying assets and the purchase price to be paid by the buyer at a later time are agreed upon by the parties.
Unlike options, a futures contract must be exercised by the buyer or seller prior to the expiration date. Futures contracts include things like currency futures, index futures, commodity futures, and so on.
- Forwards
They are financial agreements between two parties that call for the execution of the underlying securities at the agreed-upon quantity and price before the agreement’s expiration date. Like futures, forwards obligate both parties to exercise the contract prior to its expiration date. But rather than a regulated stock market exchange, investors can only trade such contracts through an OTC trading market.
- Swaps
These financial instruments can be used by two parties to swap or exchange their financial liabilities or obligations. Both parties agree to a cash flow within the contract based on an interest rate. In this contract, one cash flow is typically fixed while the other fluctuates in accordance with the benchmark interest rate.
Advantages of Derivatives
- Hedge Risks: Derivative trading allows you to hedge your cash market position. For instance, if you purchase a positional stock in the cash market, you can then purchase a Put option in the derivative market. If the stock falls in value in the cash market, the value of your Put option will rise. As a result, your losses will be minimal or non-existent.
- Low Expenses: Because derivative trading is done primarily to reduce risk, the fees are lower than for shares or debentures.
- Transfer Risks: In contrast to stock trading, derivative trading allows you to transfer risks to all parties involved in the process. As a result, your risks are significantly reduced.
Disadvantages of Derivatives
When used in conjunction with prior knowledge and extensive research, derivatives trading can provide numerous advantages for hedging or increasing profits. However, these financial instruments are complex at their core and have certain drawbacks for market participants.
- High Risk:These instruments are market-linked and derive their value in real-time from the underlying asset’s changing price. Such prices are volatile and are determined by demand and supply factors. Volatility puts such financial contracts at risk, forcing the entities to incur potentially massive losses.
- Speculation: A large portion of the derivatives market is based on a set of assumptions. Entities speculate on the underlying asset’s future price direction and hope to profit from the difference between the strike price and the exercise price. However, if the speculation goes wrong, entities may suffer losses.
- Counterparty Risk: While market participants can trade futures contracts on supervised exchanges, they must trade options contracts over the counter. It means that there is no defined system for due diligence, with the possibility of the other party failing to make a payment or exercising a promise. As a result, counterparty risk can expose market participants to financial losses.
Who is involved in the Derivatives Market?
Derivatives provide numerous advantages to market participants. However, each participating entity has a different motivation than the others, making it critical to understand how these participants affect this market and the included financial contracts.
- Hedgers
They are market participants who trade in financial contracts in order to hedge or reduce their risk exposure. Hedgers are typically manufacturers or producers of the underlying assets, which are typically commodities like oil, pulses, metals, and so on.
Financial contracts are used by hedgers to ensure that they receive a predetermined price for their produce/products if the price of the underlying assets falls within the contract’s expiration date. Hedgers ensure they mitigate their losses and get a guaranteed price by creating a financial agreement with a specific strike price.One can create such a contract and act as a hedger for any underlying asset, such as stocks, commodities, currencies, and so on.
- Speculators
They are traders who profit from the difference between the strike price (predetermined price) and the spot price (current market price) of the included financial contracts. Speculators use a variety of tools and techniques to analyze the market and forecast the future value of the underlying assets.
If they believe the underlying asset’s price will rise in the coming months, they will purchase a financial contract for that asset and sell it before the expiry date when the spot price is higher to profit. Speculators can trade in a variety of contracts, regardless of the underlying asset, which can range from equities to commodities.They usually sell the contract before the expiry date to avoid having to deliver the asset but still make a profit.
- Arbitrageurs
They are traders who profit from price differences between the same underlying securities in different markets. When such entities enter the market, they ensure that they will be able to obtain a higher price for the same underlying assets.
Once identified, arbitrageurs purchase the securities linked to financial contracts in one market, only to sell them at a higher price in another. Such entities profit from market imperfections that others are unaware of.
- Margin Traders
These traders use a portion of their investment funds to buy and sell financial contracts, but they also use stockbroker margins. They buy and sell contracts on a daily basis, and their profits are based on the price movement of the underlying assets in a single day.
When such margin traders identify profitable financial contracts, they obtain credit from stockbrokers in the form of a margin. They return the margin amount to the brokers with interest once they sell.
How To Trade In Derivatives Market?
After understanding the definition of derivatives, the next step in effective diversification and profit maximization is to learn about trading in these financial contracts. You can follow the steps outlined below.
- Before you can begin trading in various financial contracts, you must first select a reputable lender and open an online trading account. The Demat account also allows you to trade in F&O contracts. After you have opened a Demat account, you can request that your stockbroker open an account with the F&O service.
- You must pay a margin amount to the broker, which you must keep until you execute or exit the contract. If your account falls below the minimum required margin while trading, you will receive a margin call to rebalance the trading account.
- You can only trade in marketable financial contracts that have a three-month expiry date and expire on the last Thursday of the month. As a result, you must settle the contract before the specified expiry date, or it will be automatically settled on the expiry date.
FOR MORE INFO CLICK THIS SITE:https://learningsharks.in/
FOLLOW OUR PAGE:https://www.instagram.com/learningsharks/?hl=en