What is Derivative trading? Understanding: Types, Advantages & Disadvantages

India's financial market system can be divided into two main sectors: the cash segment and the derivative segment. The cash segment has traditionally been highly favored by investors. Nevertheless, there has been a remarkable upswing in the turnover and trading volume of derivatives in India in recent years.

This remarkable and rapid increase in turnover is viewed as unparalleled and extraordinary, as it has surpassed even the trading volumes of the cash segment. This level of investor enthusiasm has solidified derivatives as an optimal investment tool that holds significant potential for profitability. Well, in order to engage in derivative investments, it is crucial to possess a comprehensive understanding of the intricacies involved.

What do you mean by Derivatives?

A derivative is a financial agreement that varies in worth based on an underlying asset, group of assets, or benchmark. This agreement is established between two or more parties who can trade it either on an exchange or over-the-counter (OTC).

These agreements have the ability to be utilised for the trading of various types of assets and come with their own set of risks. The prices of derivatives are based on the changes in the value of the underlying asset. These types of financial securities are frequently employed as a means of accessing specific markets and can be traded as a safeguard against risk. Derivatives can serve the purpose of either reducing risk (through hedging) or taking on risk in anticipation of a corresponding reward (through speculation). Derivatives have the capability to transfer risk (along with its associated rewards) from those who are risk-averse to those who actively seek out risk.

For instance, the value of a stock can go up or down, and the exchange rate between two currencies can change.   Also, indices and commodity prices can fluctuate. These changes can be beneficial for investors as they can make profits, but they can also lead to losses. This is where derivatives come in handy.   They can help you earn extra money by accurately predicting future prices, or they can serve as a safety net to protect against losses in the spot market where the actual assets are traded.
 

What is the purpose of derivatives?

In Indian markets, standardised contracts for futures and options are readily tradable on exchanges, serving a multitude of purposes.

• Earn income from shares that are not being used.
  If you are hesitant to sell the shares you purchased for a long period of time, but still want to profit from short-term price changes, you have the option to utilise derivative instruments.   The derivative market enables you to engage in transactions without actually selling your shares, which is known as physical settlement.
   
• Profit from arbitrage
  Arbitrage trading refers to the act of purchasing at a low price in one market and selling at a higher price in another market. In essence, you are exploiting disparities in prices between these two markets.
   
• Hedging Protection
  Ensure the safety of your securities by safeguarding them against price fluctuations. The derivative market provides various products that enable you to protect against a decrease in the value of your owned shares.   Additionally, it offers products that shield you from an increase in the price of shares you intend to buy.
   
• Managing Risks
  The primary purpose of these derivatives is to shift market risk from cautious investors to those who are willing to take risks.   Cautious investors utilise derivatives to increase security, while risk-takers like speculators engage in risky, counterintuitive trades to maximize profits.   In this manner, the risk is passed on. Multiple products and strategies are accessible, enabling you to transfer your risk effectively.
   

If you are sufficiently interested in the advantages and wish to commence trading immediately, here is a guide on purchasing and selling future contracts. 

Types of Financial Derivatives 

There are four types of derivative agreements – forwards, futures, options, and swaps. However, at present, let us focus on the initial three. Swaps are intricate instruments that are not accessible for trading in stock markets. 

Futures and forwards are financial agreements that involve the purchase or sale of a predetermined set of assets at a specific future date for a predetermined amount. While futures contracts are standardised and traded on stock exchanges, forwards are non-standardized and do not have a market for trading.

In the derivatives market, it is not possible to purchase a contract for just one share. Contracts are always for a specified quantity of shares and have expiration dates. However, this is not the case with forward contracts, as they can be customised to meet individual requirements.

Options contracts are similar to futures and forwards contracts, with one key distinction: when you purchase an options contract, you have no obligation to adhere to the terms of the agreement. This implies that even if you possess a contract to purchase 100 shares by the expiration date, you are not compelled to do so. Options contracts are actively traded on the stock exchange.

Learn further about the concept of options trading.

There are derivative products that fall into two categories: "lock" and "option." Lock products (such as futures, forwards, or swaps) ensure that the involved parties are bound by the agreed terms throughout the contract's duration. On the other hand, option products (like stock options) grant the holder the choice, but not the requirement, to purchase or sell the underlying asset or security at a specific price before the option's expiration date. Futures, forwards, swaps, and options are the most frequently encountered types of derivatives.

The key difference between "lock" and "option" derivative products lies in the level of commitment required from the involved parties:

Lock products:

• Obligation: Both parties are obligated to fulfill the terms of the contract at the specified future date.
• Examples: Futures, forwards, swaps.
• Use cases: Hedging existing positions, locking in future prices, speculating on price movements.

Option products:

• Choice: The holder has the right, but not the obligation, to exercise the option to buy or sell the underlying asset at a set price before the expiry date.
• Examples: Stock options, currency options, commodity options.
• Use cases: Leveraged bets on price movements, income generation through option premiums, risk management by setting a minimum or maximum price for future transactions.

In short, lock products involve mandatory fulfillment, while option products offer flexibility and the potential for profit even if not exercised.

Futures Derivative

In the realm of finance, futures, known as futures contracts as well, refer to a mutual understanding reached between two parties to acquire and transport an asset at an agreed price that is to be obtained at a later date. These standardized contracts are actively traded on an exchange platform. Traders strategically employ futures contracts to mitigate potential risks or venture into predicting the value of an underlying asset. The parties involved are compelled to fulfil their obligation to either purchase or sell the underlying asset.

To help you understand this better, let's imagine a scenario: On November 6, 2023, Company A decides to buy a futures contract for crude oil at ₹4,500 per barrel. This contract is set to end on December 19, 2023. The company expects to need oil in December but is worried that the price might increase. So, they choose a futures contract to protect themselves from this risk. This decision guarantees that Company A can buy oil at ₹4,500 per barrel once the contract ends. If, by December 19, 2023, the price of crude oil goes up to ₹5,800 per barrel, Company A can decide to accept the oil delivery or sell the contract for a profit, depending on what they need at that moment. 

In this situation, both the buyer and the seller of the futures contract are reducing their risk. Company A secures its future oil needs by buying the futures contract, while the seller, who could be an oil company, protects themselves from the possibility of falling prices by selling or shorting a futures contract, fixing the selling price for December.  

Forwards Derivative

1. Forward contracts, also known as forwards, resemble futures in many ways, but they are not traded on an exchange.
2. Unlike futures, forward contracts are exclusively traded over-the-counter (OTC).
3. The terms, size, and settlement process of a forward contract can be tailored to the preferences of the buyer and seller upon creation.
4. Being OTC products, forward contracts involve a higher level of counterparty risk for both the buyer and seller.

Counterparty risks are a form of credit risk as there is a possibility that the involved parties might fail to fulfill the obligations specified in the agreement.   In case one party becomes bankrupt, the other party could face the unfortunate consequence of losing the worth of their position without any means of recovery.

After the establishment of a forward contract, the individuals involved can balance their position by engaging with other parties. This practice carries the risk of counterparty as it becomes more likely when more traders are part of the same contract.  

Options Derivative

An options agreement resembles a futures agreement in that it is a contract between two parties to purchase or sell an asset at a predetermined future date for a specific price. The main distinction between options and futures is that, unlike futures, the buyer of an option is not required to execute their agreement to buy or sell.   It is merely an opportunity, not an obligation. Similar to futures, options can be utilised to protect against risks or speculate on the price of the underlying asset.

Envision an investor holding 100 shares of a stock valued at ₹3,500 per share. While optimistic about the stock's future value, the investor seeks to mitigate potential risks and employs an option for hedging. They opt for a put option, granting them the right to sell 100 shares of the underlying stock at ₹3,500 per share—the strike price—until a specified future date, known as the expiration date.

Suppose the stock's value declines to ₹2,800 per share by expiration, prompting the put option buyer to exercise their option and sell the stock at the original strike price of ₹3,500 per share. If the put option's cost was ₹1,000, the investor incurs only the option cost since the strike price equaled the stock price when they initially acquired the put. This strategy, known as a protective put, acts as a hedge against potential downside risks in the stock.

Alternatively, consider an investor without ownership of a stock currently priced at ₹3,500 per share. Expecting the value to rise in the next month, they could purchase a call option, providing them the right to buy the stock for ₹3,500 before or at expiration. If this call option costs ₹1,000 and the stock surges to ₹4,500 before expiration, the buyer can exercise the option, purchasing a stock now valued at ₹4,500 per share for the ₹3,500 strike price, resulting in an initial profit of ₹1,000 per share. Since a call option represents 100 shares, the actual profit totals ₹100,000, less the option cost (premium), and any brokerage commission fees.

In both instances, the sellers are bound to fulfil their contract if the buyers choose to exercise it. However, should the stock's price exceed the strike price at expiration, the put becomes worthless, allowing the put seller to retain the premium as the option expires. Conversely, if the stock's price is below the strike price at expiration, the call becomes worthless, enabling the call seller to retain the premium.

Swaps Derivative

Exchange of cash flows, known as swaps, is a frequently used derivative. It allows traders to switch between different types of cash flows. For instance, a variable interest rate loan can be swapped for a fixed interest rate loan, or the opposite, through an interest rate swap.

Consider this scenario with Indian Rupees: Imagine Company XYZ borrows ₹10,00,00,000 and incurs a variable interest rate of 6% on the loan. XYZ, concerned about potential increases in interest rates leading to higher loan costs or encountering credit extension reluctance due to variable-rate risk, decides to take action.

Assume XYZ engages in a swap agreement with Company QRS, willing to exchange payments on the variable-rate loan for payments on a fixed-rate loan set at 7%. Under this arrangement, XYZ pays 7% interest on its ₹10,00,00,000 principal to QRS, while QRS pays XYZ 6% interest on the same principal. Initially, at the swap's commencement, XYZ pays QRS only the 1 percentage-point difference between the two swap rates.

If interest rates decline, causing the variable rate on the original loan to reach 5%, Company XYZ now has to pay Company QRS the 2 percentage-point difference on the loan. Conversely, if interest rates surge to 8%, then QRS is obligated to pay XYZ the 1 percentage-point difference between the two swap rates. Irrespective of interest rate fluctuations, the swap successfully fulfills XYZ's primary objective of converting a variable-rate loan into a fixed-rate loan.

Advantages and Disadvantages of Derivatives 

Advantages of Derivatives
The above instances demonstrate that derivatives can be beneficial for both businesses and investors, serving as a valuable tool. They offer the ability to accomplish the following tasks:

• Secure prices 
• Protect against negative changes in rates 
• Minimise risks 

These advantages are usually available at a minimal expense.    Derivatives can frequently be bought with borrowed funds, known as margin, thereby reducing their overall cost.

Disadvantages of Derivatives
Valuing derivatives poses a challenge due to their reliance on the value of another asset. OTC derivatives, in particular, carry uncertainties in terms of predicting and assessing counterparty risks. Additionally, the majority of derivatives are susceptible to the following factors:

• Modifications in the duration until the contract expires
• The expenditure associated with owning the underlying asset 
• Fluctuating interest rates 

These factors pose challenges in accurately aligning the worth of a derivative with the underlying asset.

Since the derivative only derives value from its underlying asset, it becomes susceptible to both market sentiment and market risk. The price and liquidity of a derivative can be influenced by supply and demand factors, which may cause it to fluctuate independently from the price of the underlying asset.

Ultimately, derivatives are typically instruments that involve leverage, and the utilization of leverage has both positive and negative impacts. While it can enhance the rate of profit, it also facilitates faster accumulation of losses.

How are derivative contracts connected to stock prices? 

If you purchase a Futures agreement for Reliance shares at Rs 3,000, which is the current spot market price, and the contract is due to expire in a month, when the stock is trading at Rs 3,500, you will earn a profit of Rs. 500 per share because you acquired the stocks at a lower price. If the price had not changed, you wouldn't have received anything. In the same way, if the stock price decreased by Rs. 800, you would have incurred a loss of Rs. 800. It is evident that the aforementioned agreement is contingent upon the price of the primary asset, which in this case is Reliance shares. Likewise, trading in derivatives can also be carried out on indices. Nifty Futures is a widely traded derivative contract in the stock markets. The underlying security for a Nifty Futures contract would be the Nifty index, which consists of 50 shares.

What are the requirements to engage in derivative trading?

In order to begin trading derivatives, you must meet three essential conditions.

• To begin with, it is necessary for you to have an operational demat account.
• Next, you will need to establish a trading account in India. If you do not already have a trading account, you could contact stockbroking firms such as TradingBells, who can assist you in setting up a trading account in India free of charge.
• Once you have successfully created both the demat and trading accounts, you will need to connect them.
• Finally, it is mandatory for you to maintain a certain percentage of cash in your trading account if you intend to engage in derivative trading. This specific amount is referred to as margin money.

Conclusion

Derivative trading can be both intricate and captivating. One of the primary benefits of derivatives is that you don't need any specific equipment or technology to begin trading them. All you need to do is open a Demat account and a trading account in India, and you'll be ready to engage in buying and selling derivatives. For those who are new to trading and just starting out, it is recommended to conduct thorough research or consult a good trading broker before entering the derivative market.