Derivatives are financial instruments that get their value from assets like stocks, bonds, commodities, or currencies. They help investors manage risk, invest wisely, and earn profits from price changes. Derivatives are traded on exchanges or directly between buyers and sellers (OTC markets). In India, they are popular among investors, traders, and institutions. This article explains the types of derivatives, how they work, and why they matter in the Indian market.
Different types of derivatives
The various types of derivatives in the Indian stock market are as follows:
1. Futures contracts
Futures contracts are standardised agreements to buy or sell a specified asset at a predetermined price on a future date. In India, futures contracts are prevalent in equities, commodities, and currencies. These contracts are traded on derivative exchanges such as the National Stock Exchange (NSE) and the Multi Commodity Exchange (MCX). Futures contracts allow investors to hedge against price fluctuations, track market movements, and leverage their positions. However, they entail the obligation to buy or sell the underlying asset at the agreed-upon price, which exposes traders to market risk.
2. Options contracts
Options contracts provide the holder with the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price within a predetermined time frame. In India, options are widely traded on stocks and indices. Options offer investors flexibility and downside protection, as they can limit losses to the premium paid for the option. Moreover, options allow traders to profit from both rising (call options) and falling (put options) market trends. However, options trading involves the risk of losing the entire premium paid if the option expires out of the money.
3. Forward contracts
Forward contracts are customised agreements between two parties to buy or sell an asset at a future date at a price determined today. Unlike futures contracts, forward contracts are traded over-the-counter (OTC) and are not standardised. In India, forward contracts are prevalent in commodities such as agricultural products and metals. Forward contracts are highly customisable, allowing parties to tailor the terms to their specific needs. However, they expose participants to counterparty risk, as there is no centralised clearinghouse to guarantee performance.
4. Swap contracts
Swap contracts are financial agreements between two parties to exchange cash flows or other financial instruments based on predetermined terms. Common types of swaps include interest rate swaps, currency swaps, and commodity swaps. In India, swap contracts are primarily used by institutions to manage interest rate and currency risks. Swaps allow parties to hedge against fluctuations in interest rates, exchange rates, or commodity prices, thereby reducing exposure to market volatility. However, swap contracts involve credit risk and may require collateralisation to mitigate potential losses.
How to trade in the derivatives market?
Trading in the derivatives market is similar to trading in the cash segment but requires a different approach. Here’s how you can trade in derivatives:
- Research and strategy – Before trading, conduct thorough research. Unlike the stock market, derivatives require a different strategy. For example, instead of buying stocks expected to rise, in derivatives, you may need to sell contracts to benefit from price changes.
- Trading account setup – Ensure that your trading account supports derivative trading. If not, consult your broker to activate this feature. Once enabled, you can place trades online or through your broker.
- Selecting stocks and contracts – Choose your stocks and contracts based on your available funds, margin requirements, and the price of the underlying asset. Since you need to pay a small amount for the contract, ensure it fits within your budget.
- Executing the trade – You can either hold the contract until expiry and pay the outstanding amount or exit earlier by placing an opposite trade.
- Stock and index derivatives – Trading futures and options is similar to buying stocks, but you do not take delivery of the underlying asset. For index futures, movements in index points influence your contract, replicating stock price fluctuations.
Conclusion
From futures and options to forwards and swaps, the Indian derivatives market offers diverse opportunities for participants to hedge and optimise their portfolios. However, it is essential for investors to understand the characteristics and risks associated with each type of derivative before engaging in trading or investment activities.
In conclusion, derivatives serve as indispensable tools for risk management and price discovery in the Indian securities market, contributing to liquidity, efficiency, and stability. By leveraging derivatives effectively, investors can navigate volatile market conditions and achieve their financial objectives with confidence.
