Understanding the tools and strategies used by professional traders will enable one to differentiate wise investing from high-stakes gambling in the bustling stock markets. One such instrument is derivatives.
Derivatives in the share market are complex financial instruments that initially seem frightening but are used daily by many, from multinational companies to individual retail traders.
The biggest derivatives market worldwide for the fifth running year in 2023 is the National Stock Exchange of India (NSE). With 8,15,99,733 contracts for stock derivative futures as of May 31, 2024, the total value of which is ₹66,23,345 crores. As of July 30, 2024, retail investors’ proportion of total trading volumes with derivative instruments is 41%.
This article will break down the meaning of derivatives in the share market, how they work, and how novice and seasoned investors can use them to their advantage.
Introduction to derivatives
Derivatives are financial instruments which derive their price from a specified underlying asset or group of underlying assets. These assets vary from shares and bonds, through commodities, and currencies, interest rates, or stock indices.
Example – A futures contract on maize lets a buyer fix a price for maize to be delivered at a later date. Should the market price of maize climb, the buyer gains by paying the reduced agreed price; should the price drop, the seller gains by getting the higher agreed price. This enables both sides to control their exposure to changes in prices.
One can hedge a position using derivatives, gamble on the direction of movement of an underlying asset, or offer leverage to holdings. Regularly traded on exchanges or OTC (Over the counter), these assets were bought through brokerages.
Derivatives markets are financial markets for buying and selling derivative contracts. They have changed financial markets for the better by providing several risk management strategies and adding complexity that calls for careful control.
To guarantee market integrity and investor protection, SEBI sets down the trading rules, participant eligibility, margin requirements, and risk management policies.
You may also like: What is the stock market index?
Types of derivatives
These 4 are the most common types of derivatives in the stock market:
Forwards contracts
A forward contract is a customised agreement between two individuals to settle a transaction at a set future date at a price agreed upon. These contracts are unique and different in size, expiration date, and asset type; they are not publicly traded, and thus, the terms are not known to the public.
Forward contracts are bilateral; thus, they carry counterparty risk. If one party wants to leave the agreement before it expires, they have to negotiate directly with the other party, who might have influence over the terms and so create possible pricing problems. Settlement usually also calls for delivering the asset on the scheduled expiration date.
Example – Consider a forward contract between a coffee shop owner and a producer. With delivery set for six months ahead, the producer agrees to sell the shop 1000 pounds of coffee for ₹50 each pound.
This contract guarantees the producer has a guaranteed sale and locks in the price for both sides, shielding the coffee shop from possible price rises.
Should coffee prices drop to ₹40 per pound in six months, the coffee shop still has to pay the agreed-upon ₹50 per pound; should prices climb to ₹60, the producer is obliged to sell at the lower price.
Futures contracts
Futures are standardised forward contracts in which the seller undertakes to make, and the purchaser undertakes to take delivery of the underlying asset at a specified price at a specified time in the future. The exchange standardised terms including expiration dates, asset types, and contract sizes unlike those of forward contracts.
Futures contracts have a mark-to-market system whereby the exchange determines a daily settlement price depending on the average of the last transactions of the day. Every party settles daily gains or losses; their accounts are credited or debited in line with this.
Example – The mark-to-market (MTM) process for a futures contract over four days is shown in the table below. You can find the daily profit or loss and track the total P&L by matching the closing prices every day to the closing price the day before.
| Day | Closing price (₹) | Previous day’s close (₹) | MTM (₹ per share) | Cumulative P&L (₹ per share) |
| 1 | 150 | 145 | 5 | 5 |
| 2 | 148 | 150 | -2 | 3 |
| 3 | 152 | 148 | 4 | 7 |
| 4 | 155 | 152 | 3 | 10 |
Revaluing the futures contract at the end of every trading day allows this table to show how the MTM process operates to ascertain the profit or loss.
Swaps contracts
Usually used to control interest rates or money risks, swaps entail the trade of assets or cash flows between two parties. Highly flexible contracts and swaps allow participants to fit the terms to their particular requirements and risk-management practices.
Hedging against several risks including credit risks, interest rates, currency, and commodity prices is mostly accomplished with swaps. Usually traded on the counter, swaps allow terms and conditions flexibility and are privately negotiated between parties.
- Interest rate swaps (IRS): Swapping floating- and fixed-rate interest payments. One party pays a floating, variable rate; the other pays a fixed interest rate. Usually used to adjust the cash flow structure or provide interest rate risk hedges, interest rate swaps.
- Currency swaps: Two parties trade principal amounts and interest payments in separate currencies. Currency swaps enable better borrowing rates in many markets and help control currency exposure.
- Commodity swaps: Changing cash flows in line with a commodities’ future price. These are used to counter swings in the cost of commodities. Entering a commodity swap helps producers guarantee a set price for the next production, guaranteeing consistent income independent of changes in the market.
- Credit default swaps (CDS): The risk of credit is transferred from one party to another through the use of financial derivatives. When someone buys a swap, they usually have to pay the seller a premium in return for protection against a specific event, an asset default, commonly referred to as a credit event.
Options contracts
Options are contracts based on any underlying asset that allows the buyer to exercise the sale effectively on or before expiration of the option in which case the buyer has the option to buy (call option) or sell (put option) the predefined pricing of the asset. This means that if the option buyer wants to exercise his or her rights, the option seller will have to meet the obligation of the buyer’s choice even if the transaction itself may not necessarily proceed.
They allowed buyers to simultaneously benefit from stocks without any risk as risk buyers in pain. Depending on the current market conditions, an option can either be positive or zero. If the option is out of the money when exercised, its owner loses the premium that is paid and has no other obligation, while the writer is entitled to any money that has been used to insure the option.
Example – An investor thinks that Reliance Industries Ltd’s stock priced at ₹2,500 is likely to increase daywise over the next three months. They pay a premium of ₹50 per share for the call option, where the strike price is ₹2,600, and the option expires after three months.
If, before the period ends, the price of the stock increases to ₹2,800, the investor’s option can then be exercised with its buy shares for ₹2600 and instant sales of the same shares at 2800 to create a profit of 150 per share, Which is 2800 – 2600 – 50 premium.
In the event that the stock does not exceed ₹2,600, the investor will not buy the option whereby the only loss will be the premium of ₹50.
Also read: Using Options and Derivatives in Investment | StockGro
Difference between cash and derivative market
Two different kinds of financial markets with different goals and features are the derivative and cash markets.
| Cash market | Derivative market | |
| Settlement | Immediate or short-term (T+2) | At a future date (specified in the contract) |
| Ownership | Direct ownership of the underlying asset | No direct ownership, only a financial contract |
| Participants | Spot traders | Futures or options traders |
| Assets | Physical assets or financial instruments | Derivatives contracts based on underlying assets |
| Purpose | Primarily for direct investment or consumption | Hedging or speculation |
| Risk | Limited to market price changes of the asset | Includes additional risks like market volatility |
Key players in the derivatives market
For various market players, derivatives have different uses and motivations that affect the dynamics of the market.
Hedgers
Hedgers are people who mostly protect against price fluctuations of underlying assets—that is, commodities like metal, pulses, and oil—using financial contracts.
A farmer might, for instance, sign a futures contract to guarantee a price for their crop, ensuring a guaranteed return even if market prices fall before harvest. They thereby reduce possible losses and stabilise their income.
Speculators
By trading financial contracts based on their projections of future market trends, speculators hope to make money from price swings.
A trader might buy a call option, for example, if they think the gold price will climb. Should the price rise before the option expires, they could profitably sell it. Usually leaving their positions before expiration, speculators help to prevent the underlying asset from being delivered.
Arbitrageurs
Arbitrageurs profit on price differences for the same underlying asset on several markets. They gain from market inefficiencies by purchasing an asset in one market at a lower price and concurrently selling it in another where the price is higher.
An arbitrageur would buy in Mumbai and sell in Delhi, so pocketing the difference if a stock is priced at ₹500 in Mumbai and ₹510 in Delhi.
Margin traders
Margin traders use borrowed money from stockbrokers to trade derivatives, increasing their buying capacity. Every day, they trade, trying to make money from transient price swings.
A margin trader might use their margin, for example, to raise their position size if they find a profitable options contract. Once they start making money, they pay back the loan, including interest.
Derivatives for risk management
By letting businesses, investors, and traders hedge against possible losses from negative price swings, derivatives help to significantly control risk. Contracts like futures, options, or swaps let market players lock in prices or shift risks connected with assets like currencies, stocks, or commodities.
Using derivatives in risk management aims mostly to reduce financial uncertainty and shield against market volatility, guaranteeing more consistent results.
Hedging with derivatives involves taking a position in a derivative contract that balances either an expected or an existing exposure.
Example – Consider an Indian oil refining company importing crude oil to satisfy its production demand. Given the great volatility of world oil prices, businesses run the danger of rising oil prices, so they raise their expenses. The business can employ a crude oil futures contract to help to lower this risk.
Should the present crude oil price be ₹7,000 per barrel, the company signs a futures contract to purchase 10,000 barrels at this price, expiring in three months. Should the price climb to ₹7,500 per barrel in three months, the business gains since it locked in the lower price of ₹7,000, thus saving ₹500 per barrel on oil purchase.
Using derivatives helps the business essentially hedge against the possibility of price rises, guaranteeing more consistent expenses and lessening market volatility. This approach lets companies concentrate on their main activities instead of being unduly worried about erratic financial losses resulting from changes in the market.
Derivatives for speculation and arbitrage
Two main ways traders leverage derivatives to profit on price swings in financial markets are speculation and arbitrage. Although both use futures, options, and other derivatives strategically, their goals and methods are different: arbitrageurs seek risk-free profits by using price inefficiencies; speculators actively take on risk in hopes of making a profit.
By betting on the future direction of prices, speculators employ derivatives, assuming positions without owning the underlying assets. Purchasing and selling futures or options lets them make money from changes in the value of assets, including currencies, goods, or stocks. Using forecasts and analysis to direct choices, speculators feed off market volatility.
Should a speculator believe the price of the underlying asset would rise, they could buy a futures contract or an option.
Example – Over the subsequent month, a trader finds Tata Motors’ stock rising from ₹650 to ₹700. Purchasing a call option for ₹650, they pay ₹50 each share. Should the stock climb to ₹700, they can exercise the option, purchasing the stock at ₹ 650 and selling it for ₹700, generating a ₹ 50 profit for every share. They merely lose the ₹50 premium paid if the price stays below ₹650.
Arbitrageurs, on the other hand, focus on creating risk-free gains by using price variations between several markets or between a derivative and its underlying asset. They simultaneously sell in another where prices are higher and buy in one market where prices are lower, so optimising the price difference without running any major risk.
When markets differ in price, arbitrage opportunities result.
Example – On the Kolkata market, gold is trading at ₹58,000 per 10 grams, but a gold futures contract on the Multi Commodity Exchange (MCX) is priced at ₹58,500 for delivery in one month. Purchasing gold on the Kolkata market for ₹58,000, the arbitrageur markets the futures contract for ₹58,500. After delivery, the arbitrageur pays the higher price for the gold and profits risk-free, ₹500 per 10 grams.
Advantages and disadvantages of derivatives
| Advantages | Disadvantages |
| Hedge against risk exposure: Derivatives let businesses and individuals guard against market risk and price volatility. | Difficult to value: Because of many elements, including underlying asset volatility and market conditions, derivatives can be difficult to price. |
| Price discovery: Derivatives support informed decision-making by helping to ascertain the future price of assets without directly purchasing them. | Counterparty risk: Exchanges do not control over-the-counter (OTC) derivatives, thus more risk of default. |
| Leverage: Derivatives let investors expose bigger positions without having to commit whole capital, possibly increasing returns. | High leverage risk: Leverage increases the potential for significant financial losses by magnifying losses just as much as it increases gains. |
| Flexibility: From hedging to speculating, they have several uses for various market players and can be implemented in several approaches. | Vulnerability to supply and demand: Sensitive to abrupt changes in the market, derivatives can cause volatility and unanticipated losses. |
How to invest in derivatives
Investing in derivatives involves understanding the risks and rewards. Here are the main ways to get involved:
- Through a broker: Open an account with a financial broker that provides options and futures, among other derivative products. Before trading, be sure you grasp the terms and conditions.
- Online trading platforms: Use websites that let you directly trade derivatives right from your computer. These sites provide a range of instruments and sometimes have lower fees.
- Exchanges: Trade straight through controlled markets like the NSE or BSE. This approach offers a safe surrounding but might need to fulfil particular standards and margin requirements.
Before diving in, research the products thoroughly and assess your risk tolerance.
Further reading: Types of Underlying Assets in Derivatives & Its Characteristics
Bottomline
Derivatives improve market liquidity, help to discover prices, and encourage financial innovation; their complex character calls for thorough knowledge and wise use. Ignorance of derivatives could lead to inadvertent exposure to risks above one’s tolerance levels.
FAQs
- Who should invest in derivatives?
Those with a higher risk tolerance and a good understanding of market dynamics may benefit the most from including derivatives in their investment portfolio. These financial contracts require expertise and familiarity with the underlying assets or markets they are based on. Derivative trading offers opportunities for hedging and speculation, making it suitable for experienced traders and institutional investors looking to manage risks and enhance returns.
- Which derivative is more risky?
OTC-traded derivatives generally carry higher risk due to the possibility of counterparty default. These contracts are traded privately between two parties and lack regulation, increasing the danger that one party might fail to fulfil their obligations. This contrasts with exchange-traded, standardised and regulated derivatives offering more security but potentially lower returns.
- Which derivatives are banned?
Capital market regulator SEBI has extended the ban on select agricultural commodity derivatives until December 2024. The banned commodities include paddy (non-basmati), wheat, chana, mustard seeds and its complex, soybean and its complex, crude palm oil, and moong. This measure aims to curb excessive speculation and stabilise prices in the agricultural sector.
- Is F&O a derivative?
Yes, F&O (Futures and options) are types of derivatives. They derive their value from underlying assets such as stocks, commodities, indices, or currencies. Futures contracts obligate the buyer to purchase, and the seller to deliver, the underlying asset at a predetermined price and date. Options contracts give the buyer the right, but not the obligation, to buy or sell the underlying asset at a specified price within a set timeframe.
- Who controls the derivatives market in India?
The derivatives market in India is primarily regulated by the Securities and Exchange Board of India (SEBI). SEBI oversees the functioning of exchanges, clearing corporations, and market intermediaries, ensuring fair, transparent, and efficient market operations. Additionally, the Reserve Bank of India (RBI) regulates interest rate derivatives, foreign currency derivatives, and credit derivatives.
