What is Derivatives Trading & How to Trade in Derivatives?| Espresso

Derivative Trading: How to Trade Derivatives in Stock Market

The derivative trading market in India has been gaining significance for the last few years. The popularity of the market has skyrocketed since it was introduced. You might be surprised to know that the daily turnover of the derivatives market on the NSE is significantly more than the turnover clocked by the cash markets of the same exchange.

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Derivatives are financial contracts whose value is dependent on an underlying asset. The underlying assets can be stocks, market indices, bonds, currencies, commodities, and interest rates. If you are looking to take part in derivatives trading, this article will help you understand the basics of how to trade derivatives in the stock market.

Four Main Derivatives Products

Here is the list of the four main types of derivatives products:

  • Forwards: Forwards are over the counter contracts between two parties who agree to buy or sell an underlying asset at a predetermined price at a pre-decided time in the future. Both the parties involved in the contract are obligated to fulfil the contract irrespective of the price of the underlying asset.
  • Futures: Futures are similar to forwards, but the buying and selling of the underlying asset take place through a standardised exchange.
  • Options: These contracts give the trader the right to buy or sell an underlying asset, but there is no obligation. The exchange can occur on or before a stipulated date and at a predetermined price.
  • Swaps: This is an agreement between two parties to trade their cash flows on a future date according to a predetermined formula. These agreements help traders manage risks that are associated with volatile currency exchange rates and interest rates.

Main Participants in the Derivatives Markets

There are majorly three types of participants in the derivatives market:

  • Hedgers: Hedgers are the participants in the derivatives market who use derivatives as a hedge against the risk associated with trading.
  • Arbitrageurs: These traders buy derivatives from an exchange where they are cheaper and sell the derivatives at a higher price on the other exchange. But, such opportunities are limited, and they do not persist for a very long time.
  • Speculators: These traders take their positions in the desired contracts based on the study of the market conditions. Derivatives are a preference for many traders because they offer higher leverage, better liquidity, and incur lesser expenses due to lower transaction costs as compared to spot markets.

How to Trade Derivatives in the Stock Market?

Here are a few steps that you have to take to trade derivatives in the stock market:

  • Open an online trading account. This is the first step that you need to take to start trading in derivatives.
  • Make an initial investment. The initial investment for trading in futures and options varies according to the different assets. For trading in options, you need to pay a certain amount of premium.
  • Build a strategy. You must have a strategy when trading strategy based on your understanding of the market, risk portfolio, availability of capital, etc.

Example of How to Trade Derivatives in the Stock Market

Suppose an investor purchases futures contracts at ₹1450 of A company with a lot size of 500. On the pre-decided date in the contract, if the stock trades at ₹1500, he makes a gain of ₹50 per share and a total of ₹25000 in total on the whole lot.

Similarly, in case the price falls by ₹50, he incurs a loss of ₹25000 on the whole lot. Therefore, it is essential to study the market and understand the trading patterns before you trade in the derivatives market.

Prerequisites to Trade in the Derivatives Market

There are two main prerequisites to trade in this market:

  • Trading account: You can conduct your trades in the market for derivatives through an online trading account. This trading account is considered your unique identity when you are trading in the markets.
  • Margin maintenance: When you trade in derivatives, you need to deposit a certain percentage of the value of the outstanding position, whether you sell or buy futures. This mandatory amount is called the initial margin. This has to be deposited up front.

In addition, the exposure margin is also levied to control the excessive speculation and volatility in the market. Besides these, you only need to maintain a mark to market margin, which is determined by the differences in the underlying asset’s value.

Things to Keep in Mind While You Trade in the Derivatives Market

There are some basic things that you need to remember while you trade in the derivatives market:

  • Do your research: It is essential that you study the markets and conduct thorough research and analysis before you start trading in the derivatives market. Just like any other market, there are risks involved in trading, so you need to understand the basics properly before you begin. Also, these markets require a time-bound and accurate view of the market.
  • Arrange the required margin: Before you start trading, you must deposit the margin amount. This margin amount keeps changing as per the stock fluctuations; therefore, you must have some extra margin amount in hand. When the underlying security price rises or falls, the margin amount also changes.

Conclusion

This is all the important information that you need to know about how to trade derivatives. It is essential that you understand the market, analyse your risk portfolio, and then start trading so that you can make profits.

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Frequently Asked Questions

The first step is to create an online trading account. Then you have to make an initial investment so that you can have the margin for trading in derivatives. After this, study the market and invest accordingly.

Derivative trading can be profitable if done correctly. However, you have to conduct meaningful research, understand the market, hedge your bets, and have an appetite for risk to make profits in derivative trading. But, like any other asset trading, derivatives trading can lead to losses, so trade only after understanding your risk portfolio.

You can learn to trade in derivatives by reading the news; you can also take free online courses and read blogs related to trading in derivatives.