Derivatives: Meaning, types, how to trade them, and more

Learn how derivatives powerful instruments derive value, hedge risks, and shape markets. Explore the potential of derivatives

By Forbes India

Published: Jun 23, 2023 04:45:33 PM IST

Updated: Aug 21, 2023 06:37:39 PM IST

Derivatives are financial instruments that have become integral to modern financial markets. Often, they form the majority of trading volumes on most exchanges across the world! These instruments, which derive value from underlying assets such as stocks, bonds, commodities, or currencies, are powerful tools for managing risk, speculating on price movements, and hedging against potential losses.

In this article, we will explore the fundamentals of derivatives, their various types, and how they function in today's complex financial landscape.

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What are derivatives?

Derivatives are financial instruments or agreements that obtain their value from an underlying asset, reference rate, index, or event. They are agreements between two or more parties that allow them to speculate on or hedge against the price movements or fluctuations in the underlying asset's value.

The value of a derivative is acquired from the changes in the underlying asset's price or other factors rather than having inherent value on its own.

If you anticipate a potential increase or decrease in the market price of a particular stock, for example, there is a risk of a financial loss if you are on the wrong side of the trade.

One can enter a derivative contract to mitigate such risks or gain from favourable market movements. In this scenario, you can place a strategic bet to generate profits or safeguard against losses in the market where the stock is traded.

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Types of derivatives

Forwards

Forwards represent customised agreements between two parties to purchase or sell an asset, product, or commodity at a predetermined price on a future date.

Unlike being traded on central exchanges, forwards are conducted over the counter and lack standardisation and control. While they do not guarantee profits, forwards are widely effective for hedging and risk reduction.

Over-the-counter forwards also carry the risk of counterparty default, which refers to the possibility of one party being unable to fulfil their obligations.

The opposing party may be left high and dry if the buyer or seller declares bankruptcy and fails to fulfil their obligations.

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Options

Options are financial contracts that give one group the right but not the duty to buy or sell securities or another financial asset. Options are comparable to futures contracts in many ways. They involve an agreement between two parties to sell or buy a specific security at a predetermined price in the future.

However, the parties are not legally bound to fulfil the contract, allowing them to sell or buy the security at any time.

Options provide an opportunity to mitigate risk in the future, especially during volatile market conditions.

Futures

Futures are financial contracts that closely resemble forwards. The main difference is that futures can be traded on exchanges, leading to standardisation and regulation. They are frequently employed for commodity speculation.

Swaps

As the name suggests, it involves exchanging one type of cash flow for another. Swaps are financial derivatives that convert one cash flow stream into a different form.

Swaps are private agreements primarily conducted over the counter and are not traded on stock exchanges.

Currency swaps and interest rate swaps are most common. For instance, an interest rate swap can be used to convert a variable-interest loan into a fixed-interest loan or vice versa.

How to trade derivatives?

Trading in derivatives involves understanding the dynamics of financial markets, which can be influenced by various factors such as economic, political, and social conditions. Any of these factors alone can trigger significant market movements.

To effectively trade derivatives and potentially earn profits, you must thoroughly educate yourself on current market situations and the factors likely to impact them. Staying informed and prepared in advance is crucial.

Here's a step-by-step guide on how to engage in derivatives trading:

Step 1: Open an online trading account to facilitate trading in different types of derivatives. If you trade through a broker, you can place orders over the phone or online.

Step 2: When you initiate derivatives trading, you will be required to allocate a margin amount, which is only withdrawable once the contract is completed and the trade is settled. If your margin falls below the minimum permissible level during trading, you will receive a margin call to rebalance it.

Step 3: It is vital to have a comprehensive understanding of the underlying asset associated with the derivative. Consider your budget and ensure it is sufficient to meet the financial obligations related to the margin requirements, available cash, and contract prices.

Step 4: Once you enter into a derivative contract, it is advisable to maintain your investment until the trade reaches its resolution. Monitoring the market and staying informed about relevant updates or developments is crucial throughout the trading process.

Derivatives vs Equity

Equity refers to the ownership capital contributed to a business by its shareholders, typically through stock purchases or capital investments. On the other hand, derivatives are financial instruments whose value is derived from the movement or performance of one or more underlying assets. While there are some commonalities, there are key differences between derivatives and equity.

The primary distinction lies in how their values are determined. Market conditions, including factors like demand, supply, company-related events, and broader economic, political, or other developments, influence equity value. Derivatives derive their value from other financial instruments, such as bonds, commodities, currencies, and various underlying assets. However, some derivatives can derive their value from equity, such as shares and stocks.

Investing in equity is typically aimed at generating profits through capital appreciation or dividend payments. It is primarily a means of participating in the ownership and growth of a company. Conversely, investing in derivatives serves not only as a speculative tool for potential profits but also as a risk management strategy. Derivatives can be used for hedging against potential risks and uncertainties in other financial positions or to take advantage of market opportunities.

Frequently asked questions ( FAQ’s)

1. How do options contracts differ from futures and forwards?

Options contracts differ from futures and forwards because they do not have to be fulfilled on a specific date. Options give the buyer or seller the right but not the responsibility to acquire or dispose of an asset at a defined price and within a given period, in contrast to futures and forwards, which impose the obligation to perform on the buyer or seller at a future date.

2. What are forward contracts?

Forward contracts involve a contractual agreement between two parties to purchase or sell an asset at a specific future date and a prearranged price.

3. Are derivatives considered safe?

While derivatives are commonly used for risk hedging purposes, trading derivatives carries inherent risks. Market volatility, counterparty risks, connectivity hazards, and liquidity risks are some types of risks associated with trading derivatives.