The Basic Types of Derivatives

The Basic Types of Derivatives

The derivatives market is widely popular among the trader’s community in India. Derivatives are financial contracts which deriveits value from the value of an underlying asset. The underlying asset can be a commodity, currency, equity, etc.  In the derivative market, the traders earn profits by speculating on the price of the underlying asset. Trading done in derivatives with proper training can prove to be really fruitful and investors can make good money. NTA® helps the traders to learn the art of reading charts and understanding the technicals to help them in earning more with the right strategy. In this article, you will learn everything that you need to know about the Types of Derivatives.

Let us first learn who the participants of the derivatives market in India are.

Participants of Derivatives Market

  • Hedgers

To secure their position in the stock market against various risks and price movements the hedgers indulge themselves in risk-averse trade. They secure their investment portfolio by taking a reverse or opposite position in the derivative segment. In order to secure their position by hedging, they are required to pay a premium to the party who agrees to take the risk.

  • Speculators

Speculators, as the name suggests are the one who takes a risk in the derivative market. They take the risk to make more profits in the derivative markets. They take a completely opposite position in comparison to hedgers and this difference in opinion helps them in making huge profits. Like for example, if the hedgers take a position expecting the market to fall, the speculators will take the position in the market expecting it to rise.

  • Margin Traders

Margin traders are those traders who participate in the derivative market using the minimum amount i.e. margin. Margin trading enables the participants to take a big position in the market by just paying a fraction of margin money. Due to the big and heavy position, a small change in the price leads to higher profits or losses in the derivatives market.

  • Arbitrageurs

Arbitrageurs are the one who use the low-risk imperfections of the market to make higher profits. They buy shares and securities at a lower price in one segment of the market and sell them later at a higher price in another market. This happens when the price of the same share is quoted at a different price in another market. Like for example, the same share can have a different price in NSE and BSE.

As we now know the different participants in derivative market, let us now learn about the different types of derivative contracts available for the participants to trade.

Different Types of Derivatives Contracts

  • Options

Option derivative contracts are those contracts that give the buyer a right to buy or sell an underlying asset. The contract is for a certain period of time and at a specified price i.e. the strike price. In this contract, the buyer has no obligation at all to exercise the option. Option writer is the term given to the person who sells options.

  • Futures

Future contracts are traded on the stock exchange. In a futures contract, an individual can buy or sell the asset at an agreed price at a specific date. The parties entering into a futures contracts have the obligation to perform the contract. The contract value changes every day and is adjusted according to the movement in the market price until the date of expiry.

  • Forwards

Forwards are similar to futures contracts. In forwards, the holder of the contract is under an obligation to perform the contract. They are available over the counter and not traded on the stock exchange. The forward contracts can be customized and made according to the requirements of the parties.

  • Swaps

When two parties exchange their financial obligations in a derivative contract, it is known as a swap. These contacts are not traded on the stock exchange and are over-the-counter contracts. These contracts are generally entered into between financial institutions or businesses.

Let us now learn about the basic things that one must keep in mind before trading in derivative markets.

Things to Keep in Mind Before Trading in Derivatives

  • The strategies that are applicable in the derivative markets are completely different from the stock market. Therefore, before you trade in derivatives you must understand and learn the functioning of the derivatives.
  • The margin amount you deposit for trading cannot be withdrawn until you settle the trade. Moreover, if there is any shortfall of money, you need to pay the additional money to settle the trade.
  • Derivative trading is possible with an active trading account. By using the services of a broker you can place the order by calling the broker or online.
  • You can remain invested in a derivative trade until the expiry period. On the expiry date, you must either settle the trade or pay the outstanding amount.

Let us now read about the advantages and disadvantages of derivatives.

Advantages of Trading in Derivatives

  • Derivatives hedges the risk exposure
  • Underlying asset determines its price
  • Increases market efficiency
  • Provides access to assets or markets that are unavailable

Disadvantages of Trading in Derivatives

  • Highly risky in nature
  • Speculative
  • Risk of default of counter-party


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