The Beginner’s Guide to Derivatives: Meaning, Types, Benefits and More

With the rapid rise in the number of mobile trading apps, the stock markets are now accessible to trades across the country. If you’ve also been enamoured by the stock markets and have a solid financial plan to use equities to create long-term wealth, it’s like you already use a mobile trading app to keep pace with the market. 

However, have you looked beyond the equity segment of the market? You may have come across instruments like futures and options in your trading app. These instruments belong to a distinct market segment for derivatives. 

Not sure what the derivatives market is and how it works? In this article, we’ll take a deep-dive into futures, options and other derivatives and see how you can benefit by adding these instruments to your portfolio. 

What is the Meaning of Derivatives?

When you buy equity shares, your gains or losses depend on how the price of that asset moves, isn’t it? However, derivatives are different. As the name indicates, they are contracts that derive their value from specific underlying assets. These underlying assets can be equity shares, stock market indices, commodities, currencies or any other asset. 

Depending on how the asset’s price moves and the effect of these price movements on the contract’s value, derivatives may become less or more expensive, as you’ll find out later in this article. And now that you know the meaning of derivatives, let’s delve into the different types of derivatives contracts available to traders. 

The Different Types of Derivatives

Derivatives are complex financial contracts that are written between market participants. They can be traded in the over-the-counter market or through stock exchanges like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE). However, not all types of derivatives are traded on exchanges, as you’ll see below. 

The most common types of derivatives contracts include the following.

Futures

Futures are standardised derivative contracts that are traded on stock exchanges. They are executed between the buyer and the seller of the contract — where one party agrees to buy the underlying asset from the other party at a specified price on a specified date. On the said date, known as the contract expiry date, the two parties are obligated to carry out the contract, irrespective of the market price of the underlying asset. This typically results in profits for one party and losses for the other. 

Let’s take a look at an example to understand this better. 

Say you expect that gold prices will rise further by the end of the month. So, on August 1, 2023, you buy a futures contract for gold at the price of Rs. 61,500 per 10 grams. The contract expires on August 31, 2023 (which is the last Thursday of the month). Now, if the price of 10 grams of gold is Rs. 62,400 on August 31, when the contract expires, you can take delivery of the requisite quantity of gold as specified in the contract at Rs. 61,500 per 10 grams instead. 

This will give you a profit of Rs. 900 per 10 grams. For the futures seller, however, it will lead to an equivalent loss. 

Forwards

A forwards contract is quite similar to a futures contract, with one key difference. Forwards, unlike futures, are only traded in the over-the-counter market segment. Because they are OTC derivatives that are not regulated by an exchange or governed by specific rules, they typically carry more risk than futures contracts. 

Swaps 

Swaps are also not traded on exchanges. They are essentially derivative contracts between two parties that decide to swap or exchange their financial obligations. One of the most commonly used types of derivatives contracts in the swap segment is the interest rate swap, where two parties may change obligations from variable to fixed interest rates or from local to global interest rates to facilitate more favourable cash flows. 

Options

Options are perhaps the most commonly traded type of derivatives in the country, right alongside futures. Like a futures contract, an options contract is also an agreement to buy or sell an underlying asset at a specified price (known as the strike price) within a specified date (known as the expiry date). Additionally, options are also traded on stock exchanges, just like futures. 

However, there is one crucial point of difference. Unlike futures, in an options contract, the buyer of the options contract is not obligated to uphold the agreement. In other words, the buyer of the options contract has the ‘option’ to exercise their right to buy or sell the underlying asset. 

Depending on the type of rights that the options contract offers the contract buyer, there are two types of options: 

• Call options, which give the buyer the right to purchase the underlying asset at a specified price within a specified date
• Put options, which give the buyer the right to sell the underlying asset at a specified price within a specified date

The Key Participants in the Derivatives Market Segment

Now that you know what the meaning of derivatives is and what the main types of derivatives are, it is essential to understand the main participants in the derivatives market. Let’s take a closer look at these details. 

Speculators

A major aspect of derivative trading involves speculating on the direction in which the price of the underlying asset may move. Speculation like this may be risky, but speculators frequently engage in this activity to profit from favourable speculation. And options and futures are both widely used in speculative trading by professionals in this strategy. 

Hedgers

Hedging is a strategy that involves taking certain positions to hedge or minimise the exposure to risk in other positions. Derivatives like options and futures are frequently and widely used to hedge existing or future positions that the investor or trader may take in the underlying asset, thus reducing the overall probability of suffering losses. 

Margin traders

Derivatives give traders the opportunity to take large positions by making a small margin money deposit with the stock broker. This can help margin traders amplify their gains if the market moves favourably. On the flip side, if the market does not move as expected, the losses can also be significant. 

Arbitrageurs

Arbitrage is the purchase and sale of the same asset in different markets, where the price of the asset may have minor differences. Arbitrageurs aim to profit off these small differences by taking large positions. For example, an arbitrageur may purchase shares in the spot market and sell equity futures of those same shares in the derivatives market. 

6 Reasons to Trade in Derivative Contracts

There are many benefits that you can experience by including derivative trading as a part of your overall investment and trading strategy. Here are some such advantages. 

The Advantage of Arbitrage

Derivatives trading offers a significant advantage through arbitrage opportunities. You can exploit price discrepancies between related assets or contracts in different markets and attempt to gain from the difference while also contributing to market efficiency and price alignment.

Protection from Volatility 

In today's unpredictable markets, derivatives act as invaluable tools to protect your investments from wild swings in asset prices. For instance, by including options in your portfolio, you can mitigate potential losses during downturns or capitalise on market upswings. 

Get the Advantage of Leverage with Margin Trading

Derivatives also give you the advantage of leverage through margin trading. With margin accounts, you can control larger positions than your regular initial investment will allow. This amplified exposure could lead to higher returns if the market moves favourably.

Hedge Existing Positions

Another reason to include derivative contracts in your portfolio is their ability to hedge existing positions. By establishing opposite positions through derivatives like futures contracts, you can offset potential losses in your other holdings. 

Liquidity 

Derivatives markets are often highly liquid, so you can quickly enter or exit positions with minimal impact on prices. This enhances market efficiency and ensures competitive bid-ask spreads.

Diversification

Derivatives also open up new avenues for diversifying your investment portfolio. They give you exposure to various asset classes and markets, reducing the overall risk and potentially enhancing returns.

The Inherent Risks in Derivative Contracts

Despite their benefits, there are also many risks that derivatives could expose your portfolio to. Get to know what they are, so you can include the necessary checks in your trading strategy.

• Market Risk: This is caused by rapid changes in derivative prices that could lead to potential losses
• Counterparty Risk: This is where one party suffers losses if the other party does not meet the obligations 
• Leverage Risk: This is caused by small market movements that could lead to significant losses in leveraged trades
• Liquidity Risk: This makes it difficult to exist your existing positions due to a lack of buyers or sellers
• Complexity: This could lead to unintended trades and exposures stemming from a lack of understanding of the market segment

Things to Keep in Mind Before Participating in the Derivatives Market

Participating in the derivatives market can be potentially rewarding if you have a solid strategy, but it requires careful consideration of some important aspects. To avoid potential pitfalls, here are some essential things to keep in mind. 

• Understand the underlying assets and derivative instruments thoroughly.
• Educate yourself about the risks and potential rewards of options and futures.
• Assess your risk tolerance levels because derivatives can be highly volatile and risky.
• Practice diversification and avoid putting all your capital into a single derivative.
• Stay updated about market trends, economic indicators and geopolitical events.
• Conduct thorough research or seek professional advice before making significant decisions.
• Establish clear investment objectives and have a well-defined exit strategy.
• Keep your emotions in check and rely on objectivity in all your trades.
• Be prepared for potential losses and avoid over-leveraging.
• Start with a small amount of capital and gradually increase exposure as you gain experience.

Conclusion

This concludes the comprehensive guide to derivatives that we’ve put together for interested traders like you. Now that you have a clear understanding of the theory and know what derivatives are in finance, you may want to practise some simulated derivative trades before you actually place real-time orders in the derivatives market. This will help you comprehend how live trading works and help you create more comprehensive and well-rounded trading strategies that help you maximise your returns and minimise your losses.