What is Derivative Trading?| Espresso

What is Derivative Trading?

In India, the financial market system can be classified into two branches - the cash market and the derivatives market. The turnover and volumes of derivative trading have increased significantly in recent years. That said, its upsurge in turnover is meteoric and has even managed to leave the cash segment behind.

 

OPEN FREE ACCOUNT

IN 15 MINS*

A strong reason behind the popularity of derivatives is that you can start trading in them without any special tools or technologies. You only need a Demat account and a trading account to get started.

Derivative Trading Meaning

A derivative is a product or contract that derives its value from an underlying asset. The underlying asset can be currencies, stocks, commodities, indices, rates of interest, or exchange rates.

Derivative trading involves buying and selling of these financial instruments in the stock market. They help you gain profits by betting on the future value of the underlying asset.

The value of the underlying assets changes frequently. For instance, the exchange rate for currencies may waver, commodity prices may rise or fall, a stock’s value may increase or decrease, or indices may fluctuate. An investor can leverage these changes to make profits. The changes can also lead to losses.

Derivatives are beneficial in these cases. You can earn an additional profit by correctly estimating the future price. Derivatives can also serve as a safety net against losses in the spot market, where the trading of underlying assets happens.

Types of Derivatives

Based on the terms of a contract, there are four types of derivatives:

  • Futures: These financial contracts obligate the parties to buy or sell the underlying asset at the agreed-upon future date and price. Both the buyer or the seller must take action at the set price, irrespective of the current market price at the expiration date. A regulated or organized exchange is responsible for futures derivatives trading.
  • Forwards: These financial contracts are similar to futures. However, there is no regulated or organized exchange executing the transaction. Since they are over-the-counter (OTC) contracts, the counterparty risk for both parties involved is higher.
  • Options: These financial derivatives grant buyers the right to buy or sell the underlying asset at a predetermined future price and date. But there is no obligation.
  • Swaps: These are derivative contracts through which two parties exchange the cash flows at an agreed-upon future date. They are also OTC contracts, and therefore, there is no regulated or organized exchange executing the transaction in the derivative market.

What is the Use of Derivatives?

It is easy to trade futures and options. You can employ the same in derivative trading in India to benefit in the following ways:

  • Protect your securities against price fluctuations

    The value of a derivative contract is derived from the price of its underlying asset. Thus, you can use these products to hedge against the risks attached with fluctuating price levels of the underlying asset.

    Let’s get an understanding of the same with an example. Suppose you buy a derivative contract, and its value moves in the direction opposite to the price of the underlying asset. You can minimize the losses of the underlying asset by using the profits from the derivatives.

  • Earn money on idle shares

    Let’s say you bought some shares for the long-term. You don’t want to sell them. However, you want to take advantage of price movements in the short term. Derivative trading helps you do so. In the derivatives market, you can execute transactions without actually selling your shares. It is also known as physical settlement.

  • Market efficiency

    Arbitrage trading is when you buy low in one market and sell high in another market. Derivative trading involves the practice of arbitrage. It ensures that the market touches an equilibrium and the value of the underlying assets is correct.

  • Transfer of risk

    One of the most vital benefits of derivatives is that the risk is transferable. Derivatives let risk-averse investors, businesses, and other parties transfer the risk to parties who have an appetite for risk. Derivatives help risk-averse investors increase safety. Conversely, risk-loving investors can perform risky, contrarian trades to increase profits. As a result, the risk is transferred. Several products and strategies are available to help you pass on your risk.

  • Low transaction costs

    These financial instruments help in reducing market transaction costs as they act as risk management tools. Therefore, the transaction costs in derivative trading are lower in comparison to other financial instruments like shares and debentures.

  • Ascertains the price of an underlying asset

    You can often use derivative contracts to determine the value of an underlying asset.

Summing up

It can get slightly difficult to understand what derivative trading is since the financial instrument is a little complex. Please note that you must perform thorough research before you enter into the segment. Besides, you must formulate effective strategies to optimize profits and minimalize losses.

Share Market Knowledge Centre

Related Articles

  • Mistakes To Avoid while Trading to Reduce Loss-Making Trades

    When you talk about investing in the stock markets, risks are the first things that come to mind. And, it’s true. Stock markets are high-risk zones since the stock prices can change within seconds based on any social, political, or macroeconomic event. 

    ...Read More
  • Things You Need to Know About Pay Only When You Profit

    While trading in the share market, you must know about the different charges. These include transaction charges, commodity transaction charges, stamp duty, brokerage charges, etc. It is also vital to understand how each of these charges is calculated respectively.

     

    ...Read More
  • How can I Trade with Zero Brokerage?

    When you decide to start trading in shares, there are a few accounts that need to be opened. First, you need a Demat account where the securities will be stored. Next, you need a trading account online with a stockbroker registered with the exchange where you want to trade. And finally, you need a banking account linked to your Demat and Trading accounts.

     

    ...Read More

Frequently Asked Questions

Derivatives are of four types - futures, options, forwards, and swaps.

Derivatives are financial instruments that do not have any independent value. To derive their value, you need to see the value of underlying assets like stock, index, commodities bullion, or currency. For instance, a derivative of Tata Capital share will derive its value from the current market share price of Tata Capital. In derivative trading, it is the contract that is traded instead of the underlying asset.

Derivatives are good hedging tools to manage price volatility. By paying a small margin, you can take a high exposure on a stock or security. For instance, if the price of the stock is ₹5 lakhs, but you only have ₹1 lakh, a derivative can help you take a position.

Derivative market trading is just like trading in the cash segment of the stock markets. There are three key requisites - Demat account, trading account, and margin maintenance.

As the instrument derives its value from the underlying assets, it can influence the prices of those assets in the short term.

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.