What are Derivatives?

Derivatives Definition

Derivatives are financial contracts, which are traded on formal exchanges or in over-the-counter (OTC) markets. This financial instrument derives its value from a group of assets or specific underlying assets. They can take the form of options, futures contracts, swaps, or forwards, with their prices closely tied to changes in these underlying assets. Derivatives serve a variety of purposes and can be used to fine-tune existing positions and speculate on the future movements of underlying assets. Participants in the world of derivatives include hedgers, speculators, margin traders, and arbitrageurs, each engaging in these financial tools to meet their distinct objectives.

How do derivatives work?

Now that you know derivatives meaning in stock market, it is equally important to understand how they work. Derivatives gain their value from underlying assets or securities and operate through two key methods including Over-the-Counter (OTC) and exchange-traded. OTC derivatives involve privately negotiated contracts, which is between two parties and offers flexibility and customization. Exchange-traded derivatives, on the other hand, are standardised contracts traded on organised futures exchanges, providing transparency and accessibility to a broader market. The core principle of derivatives is risk transfer, allowing individuals and businesses to manage and hedge against price fluctuations and other financial uncertainties.

What Are The Types of Derivatives?

Although there are many types of derivatives, the following four types are the most commonly traded in the market: 

Futures 

A futures contract refers to an agreement between the buyer and seller of an underlying asset. The buyer decides to buy an asset at a predetermined price on the contract execution date, and the seller agrees to sell the asset on the contract execution date. Futures is an obligatory contract, meaning the buyer and seller must honour the contract. 

Options 

Like futures, options refer to derivative contracts that take place between buyers and sellers. But, unlike futures, options contracts are a right and not an obligation, meaning both parties can exit the contract at any time. However, if an investor wants to exercise their rights, they can do so. The option seller is also known as the option writer, and the specified price agreed by both parties is referred to as the strike price.

Forwards  

Forwards are much like a futures contract. Here, the holder of the contract is obligated to honour the contract. But, unlike futures and options, forwards are not traded on stock exchanges and are unstandardised. Investors buy forwards through over-the-counter deals. Also, the buyers and sellers of forwards can customise the contract. 

Swaps 

Like forwards, swaps are not traded through stock exchanges and happen through over-the-counter deals between financial institutions and businesses. In swaps, the cash flow depends on a notional principal amount and not real principal. Swaps generally take place in the currency segment of stock exchanges. Now that you know of the various types of derivatives, learn about the benefits of derivative trading in the following section.

How to Trade Derivatives?

To kickstart your journey into trading derivatives and reap the benefits, here are the steps that you need to follow: 

1.    After getting familiar with the derivatives meaning in finance, set up an online trading account. This can be done directly or through a broker. This account allows you to place orders via phone or online.
2.    When you start trading derivatives, you'll need to commit a margin amount. This margin remains locked until the contract concludes, and if it falls below the minimum requirement, you'll receive a margin call to rebalance it.
3.    Ensure you have a solid grasp of the underlying asset. Keep your budget in check, ensuring it covers margin requirements, available cash, and contract prices.
4.    Stay invested in the contract until it reaches its conclusion. Consistency and informed decision-making are key throughout the trading process.
 

Advantages of Derivatives

The advantages of derivatives include the following:

●    Hedging Risks

Several hedging strategies are available for reducing risk in an individual's investment by making another investment, and derivatives are the best option for it. Derivatives act as insurance policies for risk management.

●    Low Transaction Cost

Trading in the derivatives market requires low transaction costs compared to shares, bonds, or other securities. Since derivatives serve as risk management tools, they guarantee low-cost transactions. 

Disadvantages of Derivatives

The disadvantages of derivatives are as follows:

●    High Risk

Derivatives derive their value from underlying assets. Therefore, price movements in these assets can impact these contracts. The prices of underlying assets like shares and bonds have high volatility and unpredictability. 

●    Speculative

Derivatives are often used for speculation to gain profits. Due to the unpredictability of the market, speculation is highly risky and can lead to massive losses. 

A Demat Account is All Your Need to Trade Derivatives

5paisa makes derivatives trading as easy as ABC. Visit the 5paisa website to open a free Demat and trading account and start trading instantly. You can also access the educational resources published by 5paisa to sharpen your trading skills and make bigger profits.

Examples of Derivatives

After knowing what are derivatives, you should know what are derivatives and their types. The different types of derivatives with examples are as follows:

●    Forwards

Forwards are customised agreements between two parties to purchase or sell an asset, product, or commodity at a fixed price at a later date. These are not traded on central exchanges but rather over the counter, and they are not regulated to be controlled. As a result, it is largely effective for hedging and risk reduction, even though it can't offer huge profits.

●    Futures

Futures are quite similar to forwards. But since they cannot be traded on exchanges, they are standardised and regulated. 

●    Options

Options offer the buyer or seller the right to buy or sell a financial asset or security. But they are not legally obligated to go ahead with the buy or sell at the predetermined time. In case of volatility in the market, option contracts can reduce risk in the future. 

●    Swaps

Swaps are financial derivatives used for exchanging one cash flow with another. The swaps contracts are private bindings between parties and are traded over the counter. 
 

Derivatives trading presents a unique avenue for managing risk and pursuing financial gains. The steps we've discussed, from understanding what is derivatives trading to setting up your trading account and exercising patience, provide a solid foundation. However, it's crucial to recognize that while these steps offer a starting point, ongoing learning and prudent risk management are essential for success in the world of derivatives. With these fundamental principles in mind, you can venture into derivative trading with confidence, potentially achieving your financial objectives.