What is Derivative Trading? How Does it Work?
Derivatives are specific financial contracts backed by an underlying asset. The underlying asset could be stocks, shares, currencies, commodities and interest rates. These contracts allow traders to buy or sell the contracts based on the future prices of these assets.
This type of trading allows individuals to buy or sell these financial contracts on a future date. Derivatives trading is highly popular among stock market enthusiasts as its research-backed deployment could allow opportunities to earn humongous profits.
Read on to know more about trading derivatives in stock markets and its different aspects like advantages, disadvantages, factors to consider, etc.
What Is Derivatives Trading?
Derivatives trading is purchasing or selling of financial contracts which derive their value from a specific underlying asset in stock exchanges. The expiry date of these contracts and future price at which trade may occur are predetermined.
Futures and options contracts are two of the popular derivative trading alternatives. In futures, the trading parties have an obligation to execute their contracts on or before the expiry of contracts.
In case of options, trading parties have a choice of whether they want to execute their contracts or not. They are not under any obligation to honour their contracts on or before their expiry dates.
How Does Derivative Trading Work?
Derivative trading works on the principle of speculation. Traders speculate the future price of an asset through these contracts and buy or sell them within their expiry dates. Traders can also use these derivatives as a hedging tool to mitigate risks against their existing positions in the stock markets.
Traders use derivative options to earn gains and limit their losses. Their loss is limited to the premium amount paid to the respective option writer. There are two types of options available for trading – the call option and the put option.
- The Call option gives contract holders a choice to buy assets at the predetermined price.
- The Put option gives contract holders the choice to sell underlying assets at a fixed price on or before the maturity date.
The contract value changes as per changes occurring in its underlying assets. Arbitrageurs participate in derivative trading to take advantage of the price differential in two different stock exchanges. They buy a contract in one stock market at a lower price and simultaneously sell the same in another stock exchange to gain profits.
Also Read: What is Position Trading? What are its Types, Advantages and Risks?
What Are the Types of Derivatives in Stock Markets?
Here are the types of derivative contracts available for trading:
- Futures
Derivative futures are financial contracts between two parties, i.e., a buyer and a seller. The two parties agree to execute their contract and buy or sell underlying assets at pre-agreed prices.
The trader is obligated to execute the futures contract on or before the expiry date. A stock broker or an intermediary is responsible for ensuring that the concerned parties execute these contracts.
- Options
As the name suggests, an option contract provides the contract holder with a choice to either buy or sell the asset or allow the contract to lapse. In case the contract holder decides not to honour the contract, they will lose the option premium that they had deposited while buying the contract.
- Forwards
It is similar to future derivatives in its structure and working. However, the only difference between a future and forwards derivative is that the former gets executed through a stock exchange, whereas the latter is an over-the-counter contract, and therefore comes with higher counterparty risk.
- Swap
It is also a financial contract, but it involves the exchange of cash flows. The trading parties agree to exchange cash flows at a specific future date. These are also over-the-counter agreements and therefore come with higher risks.
What Are the Requirements for Derivatives Trading?
Here are some requirements that you must fulfil in order to carry out trading in derivatives in share market:
- Electronic trading account
- Adequate funds in your accounts so that you can buy or sell contracts
- You must maintain the required margin with your stock broker. This includes both initial margin and mark to market margins.
Who Are the Participants in Derivative Markets?
Some of the participants in a derivative market segment are as follows:
- Traders or speculators
These are risk loving individuals who speculate on the future value of the underlying assets. According to their assumptions or predictions, they buy futures or options contracts. This makes a derivative trader an important source of liquidity for share markets.
- Hedgers
These participants have a low risk tolerance level. They participate in derivatives trading to mitigate risks in other positions taken by them. A hedger will determine the price of the assets and then transfer risk associated with the same to traders or speculators.
- Arbitrageurs
Arbitrageurs are individuals who seek to take advantage of the price differential of one asset in two different stock exchanges. They undertake simultaneous buying or selling of an asset in two different stock exchanges. It is a common scenario in financial markets. Under the process of arbitrage, an individual will buy a stock or asset at a low price in one exchange and simultaneously sell the same at a higher value in another stock exchange.
- Margin Traders
These traders use the initial margin amount required to be deposited with brokers to buy a higher number of stocks. Margin is just a small percentage of the total value of investment. In case of derivative trading, traders get an opportunity to earn unlimited gains but restrict their losses to the margin amount paid.
What Are the Advantages of Derivative Trading?
Some advantages of derivatives trading are as follows:
- Lower transaction costs
You can participate in derivatives trading by paying a low transaction fee compared to other trading alternatives like shares, debentures, etc. Lower costs increase net profit or gains from trading.
- Hedging tool
Individuals participating in derivatives trading primarily use them as a hedging tool. The financial contracts have the backing of an underlying asset, and they use derivative contracts to safeguard their portfolio from fluctuating price levels.
Suppose a downward movement in the price of a stock increases the value of the call option contract. Therefore, any losses faced by traders from investments in underlying assets may get offset by substantial gains earned from call options.
- Market efficiency
It creates opportunities for arbitrage trading which entails simultaneous buying or selling of an asset class. Therefore, it shifts markets more towards the equilibrium position and leads to correct price realisation of underlying assets.
What Are the Disadvantages of Derivative Trading?
The disadvantages of derivatives trading are as follows:
- Volatility
Derivatives contracts suffer from high volatility due to severe price fluctuations. Therefore, they may lead to heavy losses if not managed properly.
- High level of knowledge
These contracts require in-depth knowledge about the working of stock markets. It is not a preferred mode of investment or trading for new investors or those who cannot devote sufficient time to the intricacies of stock exchanges.
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- Speculative
As these assets are speculative in nature, they suffer from uncertainty. It is difficult to accurately predict the future direction of an underlying asset; thereby, it comes with a high level of risk.
Factors to Know for Derivatives Trading
The factors that you should consider before starting derivatives trading are as follows:
- Risk Appetite
As trading in these security contracts is a risky venture, it may be a preferable mode of investment for individuals having a high risk tolerance level. Therefore, it is imperative for traders to analyse their risk appetite before considering investing in these financial contracts.
- Maturity or Expiry Period
These contracts come with a maturity period of one, two and three months. Individuals wishing to put their money in this trading avenue must accurately come to a conclusion about the direction of markets and then choose the maturity period.
- Transaction costs
Every trading transaction entails certain fees and costs for the respective traders. It includes service fees, securities transaction tax, GST and others. Therefore, traders should go for fewer transactions as every additional transaction reduces their net gains from such trades.
Also Read: Swing Trading – Strategies, Setups, List & Pros and Cons
Final Word
There has been a significant increase in the number of people opting to put their money in derivatives trading because of its huge earning potential. This detailed guide about derivatives in stock exchanges will help readers get an idea about how this concept works and help them make an informed decision about trading in derivatives.
FAQs
Ans. Futures are standardised agreements executed and administered by various stock exchanges like NSE, BSE, etc. On the other hand, forward derivatives are custom-made contracts that suit the requirements of trading parties. Moreover, a forward derivative is an over-the-counter contract, and it will not be executed on recognised stock exchanges.
Ans. In derivatives trading, you do not receive any physical delivery of shares, so income or gains from contracts do not come under capital gains. Income from this activity may come under the income from business or profession or income from other sources head depending on whether a taxpayer is an investor or a trader.
Ans. You can follow these steps in order to trade in a derivative market:
Step1: Conduct thorough market research and analysis.
Step 2: You must maintain an adequate margin amount in your bank account before you start trading.
Step 3: Now open a trading account with a stockbroker.
Step 4: Then select the asset in which you wish to carry forward derivative trading.
An important thing about derivative trading is the timing at which you wish to execute your contract. One must be sure of the timing in order to earn substantial returns.
Ans. The charges that you must pay while undertaking derivative trading are brokerage charges, securities transaction tax, integrated goods and services tax, state and central goods and services tax, and stamp duty charges.
Ans. The holder of a futures contract is obligated to buy or sell the underlying asset at a specific price on or before the expiry date. On the other hand, a holder of an options contract is not obligated to buy or sell the asset.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
