The Indian secondary market which is commonly referred to as the stock market, allows you to trade in stocks and derivatives. Derivatives are amongst the most preferred choice of traders and investors due to a number of advantages over conventional stocks.
Derivatives are financial securities whose values are derived from an underlying asset or group of assets. Derivatives are contracts between two or more than two parties. Whenever there is a fluctuation in the price of the underlying asset, it affects the price of the derivative contract as well. These underlying assets can be stocks, indices, bonds, currencies or even commodities like silver, gold, crude oil etc.
The purpose of risk management is perfectly served by derivatives. Depending upon the roles donned by various market players, derivatives work on the principle of risk transfer.
So, without further ado, let us discuss about derivatives and their types in detail and find out which derivative instrument will be perfect for your needs.
1. The Basics of Derivatives
As we have discussed derivative instruments derive their value from an underlying asset. Derivatives are often used to hedge a position, providing leverage to holdings or speculating on the directional movements of the underlying asset.
Initially, derivatives served as a measure to balance the exchange rates for goods which are internationally traded. The values for international currencies are always fluctuating, thus there was a need for a system to account for differences. But in the modern times derivatives have many more uses and are based upon a variety of transactions.
To understand better, let us take the help of an example, imagine an Indian investor, whose investments are denominated in Indian Rupees (INR). He invests in a US company which is listed on the New York Stock Exchange using US dollars (USD). Now this particular investor will be exposed to the exchange rate risk while holding that stock. Exchange rate risk is the threat that the value of Indian Rupee will fluctuate against the US dollar. If the value of Dollar decreases, the profits earned will also be affected by the same.
To safeguard this, the investor can choose to hedge this risk by investing in a currency derivative which will lock in a specific currency exchange rate. Such derivatives which are used to hedge similar risks include currency futures mainly.
Derivatives are traded on the stock exchanges and are also used by institutional investors for hedging risks and also to speculate the price changes in the value of the underlying asset. The derivatives which are traded on the exchanges are standardized and have lower risks compared to over the counter derivatives. Derivative instruments are leveraged instruments and thus have a high risk to reward ratio.
2. Types of Derivatives
There are four different types of derivatives which are traded in the market. These are used for speculation, risk management and leveraging a position. Derivatives are a growing marketplace and offer an instrument for almost every need and risk appetite. Let us discuss about the different types of derivatives in detail:
Futures: Futures or future contracts are one of the most widely traded derivative instrument. It is an agreement between two persons for the delivery and purchase of an asset at a pre-agreed price on a future date. Future contracts are traded on the exchange and are standardized. Trader use future contracts for hedging risks or speculating the price of the underlying asset. When you are involved in trade of a futures contract, you are obligated to fulfill the commitment of buying or selling the underlying asset on the particular date.
Forward Contracts: Forward contracts or forwards are very similar in nature to futures. The point which differentiates forwards from futures is that unlike forwards, futures are not traded on the exchange. Forwards are only traded over the counter. When creating a forward contract, the buyer and seller can customize the terms, size and settlement process of the derivatives. Being an over the counter instrument, forward contracts carry more counterparty risks for both seller and buyer.
Swaps: Swaps are used for exchange of one financial instrument for another between two parties. This exchange is done on a predetermined time, as per the contract. Swaps are not traded on the exchange and are also an over the counter instrument like forwards. The dealing in swaps are usually oriented through banks. Swaps are used for hedging various kind of risks including currency risk and interest rate risk.
Options: Options contract is an exchange-oriented instrument and works similar to a future contract. It is an agreement between a buyer and seller to buy or sell an asset on a predetermined future date for a specific price. The main difference between futures and options is that the option buyer is not obliged to exercise their agreement for buying and selling. Option is an opportunity and not an obligation, whereas with futures, it is an obligation. Options can also be used for hedging or speculating the price of the underlying asset.
Options and Futures are the two derivative instruments which are usually traded in India through the stock exchanges. The trading process is very similar to stocks, which means that you need to have a demat account and a trading account with a broker who provides trading service in derivative instruments.
Conclusion
Derivatives are a very lucrative investment and trading option for the investors because of their nature of high risk and high return. But it should be noted that trading in derivatives is very different from trading in conventional stocks and thus it requires a proper knowledge and experience. Delta Derivative Plus can help you to capture the big swings of the market using derivatives. It provides risk management by using a trailing stop loss. You can also take the help of Equity Derivative Pack if you want to trade exclusively in equity derivatives only.
Happy Trading!
