What Is Derivatives Market

By Author: AtishPatil
Total Articles: 2
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There are a lot of participants who are drawn to the spot or the cash shares market in India. However, there is a bigger market that exists apart from stocks which is called the derivatives market. The turnover in this market is much higher than that in the stock market.

If you’re considering doing derivatives trading, then you need to be aware of a few things about future and options trading.

Here are things to know before investing in derivatives market:

What are derivatives:

Derivatives are instruments that derive their value based on an underlying asset. For example, a stock option will derive its value based on the price of the stock. A commodity future, soyabean futures for example derive their value on the price of soyabean in the market at the current date and time. Some of the common types of underlying assets are:

Shares
Index
Commodities
Currencies

These derivatives are for 1 month, 2 month and 3 months expiry. These contracts expire on the last Thursday of each month.

Types of derivatives instruments:

Before you invest in derivatives, it is important to know the types of derivative instruments so that you can decide which one you would like to invest in. Once you select the derivative instrument, you can pick the investment strategy.

Forwards:

Forwards are a contractual agreement between two parties for delivery of a particular asset at a fixed price. Forwards benefit both the seller and buyer since it locks the price for delivery. This contract has to be fulfilled by both the parties. It is a non standardized agreement and cannot be traded on the stock exchange

Futures:

Futures are standardized agreements that are traded on the stock exchange. It is similar to a forward contract except that it is standardized between the two parties. The lot size and the price is transparently available to all who do derivatives trading. It is possible to exit a forward before expiry i.e not take delivery on it.

Options:

Options give the buyer the right but not the obligation to buy or sell the underlying asset on date of delivery. For example, if you buy an index option and you are not making any money on it till delivery, you can choose to not exercise the option and it will lapse and your loss will be restricted to the options premium you paid to buy the option. Options have a premium on it called as option premium.

Swaps:

Swaps are an agreement between two parties to exchange cash in the future based on certain pre-decided criteria. Some types of swaps are currency and interest rate swaps.

Market participants:

Primarily, there are three participants entering the derivatives market in India.

Hedgers:

Hedgers enter the derivatives market to supplement or reduce their risks on existing contracts. For example, a company with exposure to foreign exchange can enter into currency derivatives to hedge their losses against foreign currency fluctuations. A company that is into cotton or soyaban can enter into commodity derivatives for price protection. The main purpose for such parties is to reduce their risks and to fix in on a price that can reduce their exposure to fluctuating spot prices.

Traders:

Traders enter the derivatives market to take positions on different instruments and earn a return on derivatives trading. Traders don’t necessarily stay invested in the instruments till their expiry. They may close positions whenever they earn a profit. Since traders close their open positions before expiry, there is no delivery involved.

Arbitrageurs:

Arbitrageurs are those who profit from the difference in prices between two markets. It takes a lot of technical knowledge to be an arbitrageur.

The derivatives trading depends on the type of instruments you invest in and your purpose of investing in the stock market.