Understanding Derivatives Market

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The derivatives market was introduced in India in the year 2000, and since then derivatives market has been gaining great significance, just like its counterpart abroad.

Just like shares, Derivatives are also traded in stock exchanges. Derivatives are a type of security whose value is derived from an underlying asset.

These underlying assets can be stocks, bonds, commodities, or currencies. The popularity of derivatives can easily be understood by the daily turnover in the derivatives segment on the exchange, which is much higher than the turnover in the cash segment on the same exchange.

What is a Derivatives Market?

Derivatives can either be exchange-traded or traded over the counter (OTC). Exchange refers to the formally established stock exchange wherein securities are traded and have a defined set of rules for the participants.

Whereas OTC is a dealer-oriented market of securities, which is an unorganized market where trading happens by way of phone, emails, etc. Derivatives traded on the exchange are standardized and regulated.

On the other hand, OTC derivative constitutes a greater proportion of derivatives contracts, but it carries higher counterpart risk and is unregulated. These financial instruments help in making a profit by simply betting on the future value of the underlying asset.

Hence the name derivative as they derive the value from the underlying asset.

For instance, Derivative contracts are used by wheat farmers and bakers in order to hedge their risk.

The farmer fears that any fall in price would impact his income. Hence enters, the contract to lock in the acceptable price for the given commodity. On the other hand, the baker, in order to hedge his risk on the upside, enters the contract so that he does not suffer losses with a rise in price.

Derivative contracts like futures and options trade freely on exchanges and can be employed to satisfy a variety of needs which includes the following-

1. Hedge your securities

The derivative contracts can be used to hedge your securities from price fluctuations.

The shares which you possess can be protected on the downside by entering into a derivative contract.

Moreover, it also protects you from the rise in the share price which you plan to purchase.

2. Transfer of risk

This is the most important use of derivatives which helps in transferring risk from risk-averse people to risk-seeking investors.

The risk-seeking investor can enter into risky contrarian trades to gain short-term profits.

While the risk-averse investor can enhance the safety of their position by entering into a derivative contract.

3. Benefit from arbitrage opportunities

Arbitrage trading simply means buying low in one market and selling high in another market.

So with the help of derivative contracts, you can take advantage of price differences in two markets.

Thus it helps in creating market efficiency.

Difference between Cash Market and Derivative Market

• In the cash market, we can purchase even one share, whereas, in the case of futures and options, the minimum lots are fixed

• In the cash market, tangible assets are traded, whereas in derivatives contracts based on tangible or intangible assets are traded.

• The cash market is used for investment. Derivatives are used for hedging, arbitrage, or speculation.

• In the case of the cash market, a customer must open a trading and demat account, whereas, for futures, a customer must open a futures trading account with a derivative broker.

• In the case of the cash market, the entire amount is put up upfront, whereas, in the case of futures, only the margin money needs to be put up.

• When an individual buys shares, he becomes part owner of the company, whereas the same does not happen in the case of a futures contract.

• In the case of a cash market, the owner of shares is entitled to dividends, whereas the derivative holder is not entitled to dividends.

Participants

The participants in the derivatives markets can be segregated into three categories, namely-

1. Hedgers

These are traders who wish to protect themselves from the risk or uncertainty involved in price movement. They try to hedge their position by entering into an exact opposite trade and pass the risk to those who are interested in bearing the same.

By doing this, they try to get rid of the uncertainty associated with the price. For example, you have 1000 shares of XYZ Ltd., and the CMP is Rs 50. You are planning to hold the stocks for 6-9 months, and you expect a good upside.

However, in the short term, you feel that the stock might see a correction, but you do not want to liquidate your position today as you are expecting a good upside in the near term.

For example, you can enter into an options contract (a part of the derivative strategy) by paying a small price or premium and reducing your losses.

Moreover, it would help you benefit whether or not the price falls. This is how you can hedge your risk and transfer it to someone who is willing to take the risk.

2. Speculators

They are extremely high-risk seekers who anticipate future price movements in the hope of making large and quick gains.

The motive here is to take maximum advantage of the price fluctuations.

They play a very key role in the market by absorbing excess risk and also providing much-needed liquidity in the market when normal investors don’t participate.

Read our ELM Module on Derivatives

3. Arbitrageurs

Arbitrage is a low-risk trade that involves buying securities in one market and simultaneously selling it in another market.

This happens when the same securities are trading at different prices in two different markets.

For instance, say the cash market price of a share is Rs 100, and it is trading at Rs 110 per share on the futures market.

An arbitrageur observes the same and buys 50 shares @ Rs 100 per share in the cash market and simultaneously sells 50 shares @Rs 110 per share, thus gaining Rs 10 per share.

Types of Derivatives Contracts

There are four types of derivative contracts which include forwards, futures, options, and swaps.

Since swaps are complex instruments that we cannot trade in the stock market, so we’ll focus on the first three.

1. Forward contracts

They are customized contractual agreements between two parties where they agree to trade a particular asset at an agreed-upon price and at a particular time in the future.

These contracts are not traded on an exchange but privately traded over the counter.

2. Futures contracts

These are the standardized versions of the forward contract, which takes place between two parties where they agree to trade a particular contract at a specified time and at an agreed-upon price.

These contracts are traded on the exchange.

3. Options

Options is an agreement between a buyer and a seller which gives the buyer the right but not the obligation to buy or sell a particular asset at a later date at an agreed-upon price.

You can also do our course on  Certification In Online Options Strategies

Difference between Forward and Futures Contracts

The main difference between forward and futures contracts are:

• Forward contracts are traded on a personal basis, while future contracts are traded in a competitive arena.

• Forward contracts are traded over the counter, whereas futures are exchange-traded.

• Forward contracts settlement takes place on the date agreed upon between the parties, whereas futures contracts settlements are made daily.

• The cost of forward contracts is based on the bid-ask spread, whereas futures contract has brokerage fees for buy and sell order.

• In the case of forwards, they are not subject to marking to market. On the other hand, futures are marked to market.

• Margins are not required in the case of a forward market, whereas in futures, the margin is required

• In a forward contract, credit risk is borne by each party, whereas in the case of futures, the transaction is a 2-way transaction; hence both parties need not bother about the risk

Different Types of Futures Contracts

Depending on the underlying asset, there are different types of futures contracts available for trading.

They are: –

1. Individual stock futures-

They are contracts between 2 investors.

The buyer promises to pay a specified price for, say, 500 shares of a single stock at a predetermined future point.

The seller promises to deliver the stock at a specified price on a specified future date.

2. Stock index futures

The underlying asset is the stock index. Stock index futures are more useful when one is speculating on the general direction of the market rather than the direction of an individual stock.

It can be used for hedging a portfolio of shares.

3. Commodity futures

Here the underlying asset is a commodity like gold, silver, nickel, crude oil, etc.

In India, commodity futures are traded on 2 exchanges, namely MCX, i.e., Multi Commodity Exchange, and NCDEX i.e., National Commodities and Derivatives Exchange.

The following are some examples of commodities – pulses, cereals, fiber, oil and seeds, energy, metals, and bullion.

4. Currency futures

These are exchange-traded futures contracts that specify the price in one currency at which another currency can be bought or sold at a future date.

These are legally binding, and the parties that hold the contracts on the expiry date must deliver the currency amount on the specified date at the specified price.

5. Interest rate futures

The underlying asset, in this case, is the debt obligation which moves according to the changes in the interest rates.

Types of Margins

There are basically three types of margins in derivative trading. These are the Initial margin, Maintenance margin, and Variation margin-

1. Initial margin

It is the initial cash that you must deposit in your account before you start trading.

This is required to ensure that the parties honor their obligation and provides a cushion to the losses in the trade.

In simple words, it is like the down payment for the delivery of the contract.

2. Maintenance Margin

It is a cash balance that a trader must bring to maintain the account, as it may change due to price fluctuations. The maintenance margin is a certain portion of the initial margin for a position.

If the margin balance in the account goes below such margin, the trader is asked to deposit the required funds or collateral to bring it back to the initial margin requirement.

This is known as a margin call.

3. Variation Margin

As soon as the margin falls below the maintenance margin, you need to deposit cash or collateral to bring the account back to the initial margin.

You can also watch our video by Mr. Vivek Bajaj

Frequently Asked Questions

Bottomline

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