February 20, 2025
8 mins read
If you have ever monitored stock prices or currency rates, you likely know about derivative trading. It sounds complicated, but it refers to trading contracts based on the future value of underlying assets—such as shares, gold, or currencies.
In derivative trading, you do not own the underlying asset. Instead, you are agreeing on an exchange of the asset at a set price on a future date. Derivatives can be used for risk management, to protect profits, or to speculate on price movement. Many traders in India trade derivatives to hedge and manage uncertainty.
Before you start, you should know that derivatives come in different forms. Each serves a specific purpose depending on how you want to use them—whether to reduce risk, earn profits, or diversify your trades. Here are the main types you should understand.
Futures: Futures contracts allow you to agree today to buy or sell an asset at a specified price in the future. You can use them to help you plan better, reduce price uncertainty, or worry less about it. Futures contracts can be traded on a futures exchange; therefore, you will obtain a level of transparency and proper settlement.
Options: Options give you flexibility. An option gives you the right—but not the obligation—to buy or sell an asset at a given price. Therefore, you can use options to protect your current investments or to take advantage of market movements while minimising your initial investment.
Forwards: Forwards operate almost the same as futures except that forwards are agreements between two parties where a forward contract can be tailored to your needs (e.g., contract size, price and delivery date), and because of this customisation, forwards are private agreements. Since forwards are not regulated, forwards carry a larger counterparty risk.
Swaps: Swaps help you hedge risks over the long term. A swap is where you can exchange one type of cash flow for another – usually an interest rate or currency-based swap. To illustrate, you might swap fixed interest payments for floating interest payments as a way to hedge your exposure to rate changes.
Now, before we jump to the advantages or disadvantages of derivatives trading, why not first understand what is derivatives trading.
Well, to put it in the most simple terms, derivative trading involves buying or selling derivatives, ones whose value comes from the underlying instrument. The best part about derivatives trading is that they allow you to buy a large amount with a small margin.
Here are some compelling advantages of derivative trading.
One of the most prominent benefits of derivatives trading is that they allow you to hedge risks. How, you ask? Say you bought a stock in exchange, and now you consider buying contrasting options in the derivatives market. Now, in case the value of your stock declines, this will ultimately lead to a rise in the value of your put options. Thus, reducing your overall risks.
As derivatives are popular as risk-mitigating tools, the transaction costs of derivative markets and trading are comparatively lower than other instruments like equities, debentures, etc.
Another prominent advantage of derivatives trading is that risks here are transferable. This means traders, investors, or more may transfer their risks to other parties or shareholders. This also comes in handy in spreading and, thus, reducing the risk.
As mentioned, engaging in the derivatives market gives you quite some leverage. Plus, traders can buy large quantities even with small amounts. However, before you start engaging in the derivatives market, it's important you understand and be careful of some of the disadvantages of derivative trading.
Derivatives are market-linked and as mentioned, their value is derived from underlying assets, like stocks. Now, when the underlying assets are volatile, with their prices fluctuating rapidly, the value of derivatives also fluctuates, making them highly risky. This may sometimes lead to big losses for traders.
The basic design of derivatives is to speculate or you may say they are highly based on assumptions. Such speculations about price fluctuations, market movements, and more can go wrong sometimes leading to huge losses.
Some derivatives, like futures, are traded on market exchanges like National Stock Exchange or Bombay Stock Exchange. However, there are derivatives, like forwards or swaps, that are OTC contracts. This means these are not regulated or standardized by any particular authority. Thus, opening the chances of payment defaults or other risks from the other party involved in the process.
Now that you have read about the advantages and disadvantages of derivatives let's quickly have a look at some popular uses of these derivatives.
Let's say you have some idle shares with you. Now, you plan to hold these for a long term. However, you also want to benefit from these shares. Here are derivatives which can help you earn from short-term fluctuations of such stocks. These allow you to make money and trade without the need to sell your shares.
You may also enjoy the benefits of arbitrage trading. Here, you may consider buying an asset at a comparatively lower price in a particular market and then selling it at a higher rate in another market. This helps you earn from the price differences between the two markets.
One of the most prominent uses or advantages of derivatives is that it helps you financially secure your investments. You may use them to hedge in case you're speculating about price fluctuations of your shares or securities.
As mentioned earlier, with derivatives you may also transfer your risk. Investors willing to reduce their risks use derivatives to transfer the same to individuals willing to make more profits.
If you are considering participation in derivatives, it is important to remember that there are many participants in the market, from large institutions to individual traders, which contributes to liquidity and price formation
Hedgers - If you worry about the potential for sudden price fluctuation, then you are a hedger. You use derivatives or other mechanisms to lock the price in to secure your position. This is most common, for instance, amongst investors or businesses that deal with commodities or foreign exchange.
Speculators - Speculators seek to profit from price movements by identifying opportunities. You do not need to own the asset to profit from price increases or decreases. While speculation carries inherent risks, it is necessary to maintain market liquidity, thereby keeping prices competitive across markets.
Arbitrageurs - Arbitrageurs seek to exploit price differences across markets. You can buy an asset for a lower price in one market and sell it for a slightly higher price in another market. With this arbitrage, you move prices back toward a fair price, thereby eliminating market inefficiencies.
Margin Traders - Margin traders utilise leverage to trade larger positions while using smaller funds. Margin trading requires you to deposit a small portion of the value of the trade and borrow an amount towards the total trade amount. This increases your exposure and potential loss and therefore requires tighter controls.
If you've read up till here, you've already read about derivatives, their uses, advantages, disadvantages, market, etc. Now, let's explore deeper and understand how to trade in the derivatives market. Here is your step-by-step guide.
First, consider searching and then choosing a reputed lender for yourself. Now open an online trading and demat account to start with your futures and options contract.
Also, you must understand that you will need to have to pay a margin amount to your broker. This helps maintain your orders. In case your account falls below a certain margin, you are likely to get a margin call. This is a warning to rebalance your account.
Further, you may only trade in contracts that can be purchased/sold in the market. Also, you need to settle your contracts before the expiry period.
To give derivatives trading a go, make sure you fulfil all the prerequisites. As mentioned, start with having a demat and trading account of your own. Once done, make sure to have enough funds in your account to facilitate exchange in the share market. In most cases, this amount is equivalent to the margin required for your contract. Further, you may consider contacting your broker for more information on the derivatives market, derivative trading, minimum investment, and other information
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The value of derivatives depends very much on the underlying assets. This means their volatility may fluctuate given if underlying assets are risky or volatile. However, with proper market research and knowledge, these may turn out to be low-risk instruments.
Futures are a type of derivatives. These contracts come with an obligation between two or more parties. In addition to futures, there are some other types of derivatives as well, including options, swaps, etc.
The main purpose of derivative trading differs for different participants. For example, for hedgers, the main goal might be to hedge risks, while for speculators, it might be to earn profits from predictable price movements.
Yes, like any other financial instruments, derivatives are also not risk-free. You might end up losing your money with derivative trading in case of bad speculation and certain other circumstances.
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