Published on: January 15, 2024
Derivatives trading has gained significant prominence in the Indian financial markets, providing investors with opportunities to manage risk, speculate on price movements, and enhance portfolio returns.
Let’s understand what derivatives are, the types of derivatives, characteristics and risks associated with derivatives.
What are Derivatives?
Derivatives are financial instruments whose value is derived from an underlying asset. In the Indian context, the most common underlying assets include equities, commodities, currencies, and interest rates. The primary purpose of derivatives is to allow market participants to hedge risk or speculate on future price movements.
For example, if you buy an orange from a fruit seller, it is an underlying asset, while its juice will be termed its derivatives.
Types of Derivatives in Indian Markets
1. Futures Contracts:
Futures contracts are a key component of the derivatives market, serving as a powerful tool for investors to manage risk, speculate on price movements, and enhance portfolio performance. In this detailed explanation, we will delve into the intricacies of futures contracts, exploring their definition, characteristics, trading mechanics, and practical examples.
a. Definition of Futures Contracts:
A futures contract is a standardised financial agreement between two parties to buy or sell an underlying asset at a predetermined price on a specified future date. The underlying asset can be commodities, financial instruments, currencies, or stock indices.
b. Characteristics of Futures Contracts:
Standardisation: Futures contracts are highly standardised regarding contract size, expiration date, and other terms. This standardisation facilitates trading on organized exchanges.
Expiration Date: Each futures contract has a predetermined expiry date when the contract is settled. The expiration date provides clarity on when the contract must be fulfilled.
Marking to Market (MTM): Daily settlement, known as marking to market, ensures that gains or losses are realised daily. The contract’s value is adjusted based on the market price, and profits or losses are credited or debited to the trader’s account.
c. Mechanics of Futures Trading:
Long and Short Positions: Traders can take either a long position (committing to buy the asset) or a short position (committing to sell the asset). Long positions profit from price increases, while short positions profit from price decreases.
Margin Requirements: Futures trading involves a margin, a security deposit that traders must maintain to cover potential losses. An initial margin is required to open a position, and a maintenance margin ensures ongoing coverage.
Leverage: Futures contracts offer significant leverage, allowing traders to control a prominent position with relatively little capital. While leverage magnifies profits, it also increases the potential for losses.
d. Purpose of Futures Contracts:
Risk Management: One of the primary purposes of futures contracts is to manage risk. Businesses, investors, and traders use futures to hedge against adverse price movements in the underlying asset, thereby minimising potential losses.
Speculation: Futures markets provide a platform for speculators to profit from anticipated price movements. Traders can take positions based on their market outlook, aiming to capitalise on price fluctuations.
e. Example of Futures Trading:
Suppose an investor believes that the stock of TCS, currently trading at Rs.4,000, will increase in the next two months. The investor decides to go long on a TCS Futures contract expiring in two months at a price of Rs.4,000.
The investor profits from the price difference if the TCS price rises to Rs. 4,100 on or before the contract’s expiration. Conversely, the investor incurs a loss if the price falls to Rs. 3,900.
2. Options Contracts:
Options trading is a significant component of the financial markets, providing investors with versatile strategies for hedging, speculation, and income generation.
a. Understanding Options Contracts:
Options are financial instruments that provide the holder with the right, but not the obligation, to buy (Call Option) or sell (Put Option) an underlying asset at a predetermined price before or at the expiry date.
The underlying asset can be stocks, indices, commodities, or currencies.
- Call Options (CE):
A Call Option gives the holder the right to buy the underlying asset at a specified price (strike price) before or at the expiration date.
Example: An investor buys a Call Option for 100 shares of XYZ Ltd. with a strike price of ₹120 and an expiry in one month. If, at expiration, XYZ Ltd. is trading at ₹130, the investor can exercise the option and buy the shares at the agreed-upon ₹120, realising a profit.
- Put Options (PE):
A Put Option gives the holder the right to sell the underlying asset at a specified price (strike price) before or at the expiration date.
Example: An investor buys a Put Option for 100 shares of ABC Ltd. with a strike price of ₹90 and an expiry in one month. If, at expiration, ABC Ltd. is trading at ₹80, the investor can exercise the option and sell the shares at the agreed-upon ₹90, realising a profit.
b. Characteristics of Options Trading:
Premium: The price paid for an option is called the premium. It represents the cost of acquiring the right to buy or sell the underlying asset.
Expiration Date: Options have a finite lifespan and expire on a predetermined date. Investors must exercise their options before or at the expiration date.
Strike Price: The agreed-upon price at which the underlying asset will be bought or sold if the option is exercised.
American vs. European Options: American options can be exercised at any time before or at expiry, while European options can only be exercised at expiry. In India, we trade European Options known as Call European (CE) or Put European (PE).
c. Option Trading Strategies:
Covered Call: An investor owns the underlying asset and sells a Call Option to generate income.
Protective Put: An investor buys a Put Option to hedge against potential downside risk in the underlying asset’s value.
Straddle: Simultaneously buying a Call Option and a Put Option with the same strike price and expiration date, anticipating a significant price movement.
d. Example of Options Trading:
Suppose an investor is bullish on the stock of XYZ Ltd., currently trading at ₹150. The investor buys a Call Option with a strike price of ₹160 and an expiry in one month for a premium of ₹5 per share.
If, at expiration, the stock price rises to ₹170, the investor can exercise the Call Option, buying shares at ₹160 and selling them at the market price of ₹170, realising a profit.
e. Risks Associated with Options Trading:
Limited Loss, Unlimited Gain: The maximum loss for an options buyer is the premium paid, while potential gains can be unlimited. It’s vice versa for options sellers.
Time Decay: Options lose value as they approach expiry, known as time decay. This can erode the premium paid.
Market Risk: Options are subject to market fluctuations, and adverse price movements can result in losses.
We would suggest you use an effective options trading terminal to trade options smartly.
3. Forward Contracts:
Similar to futures contracts, forward contracts are agreements between two parties to buy or sell an asset at a future date, but they are traded over-the-counter (OTC) and are not standardised.
Example: A farmer enters into a forward contract to sell a specific quantity of wheat to a flour mill at an agreed-upon price after three months.
Characteristics of Derivatives
1. Leverage:
Derivatives allow investors to control a prominent position with relatively small capital, amplifying gains and losses.
Example: An investor buys a futures contract for 100 shares of a stock with only a fraction of the total contract value as margin.
2. Speculation:
Traders can use derivatives to speculate on price movements, potentially profiting from both upward (long position) and downward (short position) market trends.
Example: A trader sells a futures contract for crude oil, anticipating a decline in its price.
3. Hedging:
Investors use derivatives to hedge against adverse price movements in the underlying asset, reducing the impact of market volatility on their portfolios.
Example: A portfolio manager holds a significant position in a tech stock and uses index futures to hedge against a potential market downturn.
Risks Associated with Derivatives Trading
1. Market Risk:
The value of derivatives is subject to fluctuations in the underlying asset’s price.
Example: A trader who holds a call option on a stock may face losses if the stock price falls below the option’s strike price.
2. Liquidity Risk:
Some derivative contracts may lack liquidity means lacks trading volumes, making buying or selling positions at desired prices challenging.
Example: An investor holds a futures contract for a thinly traded stock, experiencing difficulty executing trades due to low market activity.
3. Counterparty Risk:
OTC derivatives expose participants to the risk of default by the counterparty.
Example: Two financial institutions enter into a forward contract, and one fails to fulfil its obligations, leading to potential financial losses for the other party.
Regulatory Framework in India
1. Securities and Exchange Board of India (SEBI):
SEBI regulates the derivatives market in India, establishing rules and guidelines to ensure transparency and investor protection.
2. Exchanges:
The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are India’s primary exchanges for trading stock derivatives.
The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are India’s primary exchanges for trading stock derivatives.
The National Commodities & Derivatives Exchange Ltd (NCDEX) and Multi-Commodity Exchange (MCX) are India’s primary exchanges for trading commodities derivatives.
If you wish to trade in derivatives, you must learn some derivatives trading strategies to aid your trading journey. You can also enhance your learning with educational videos on trading options and futures.
The world of Derivatives may seem overwhelming at first, but with the right guidance, practice and discipline, any trader can master it. Derivatives trading is a great way to diversify your portfolio and potential earnings. But, before you begin, we suggest you expand your knowledge of derivatives. You can check our Insight platform for free educational videos or Shelf for books written by experts.
