Introduction to derivatives market
Derivatives market is a market for financial instruments such as futures, options or contracts. These financial instruments help you make profit by betting on the future value of the underlying asset. So since their value is derived from the underlying asset, they are called as derivatives.
Derivative and equity is the driver of their value. Equity gets its value based on market conditions such as demand and supply and company related events. Whereas, derivatives are financial contracts that derive their value from an underlying asset. This asset could be in the form of stocks, indices (index), currencies, exchange rates or rate of interest. The value of these underlying assets keep changing; for example, a stock’s value may rise or fall, indices may fluctuate, rate of interest also keeps varying. These changes can help you make profits but can also cause losses.
By using different types of derivatives, you can remove the need to invest a large amount of capital upfront. A derivative allows you to benefit from market movements. If you are good at anticipating market movements, derivatives are useful since they allow you to earn returns quickly. They also double up as an effective tool to hedge risks. The classical derivative definition is - a derivative is a contract between two or more parties whose value is based on an agreed- upon underlying financial asset or set of assets.
If you learn about derivatives, it is very important to understand that how traders in derivatives market benefit from derivatives trading:
Hedging against price fluctuations – Derivatives help hedgers in derivatives market to protect their securities against fluctuations in prices of the underlying asset. The derivative market offers products that allow you to hedge yourself against a fall in the price of your shares. It also offers products that protect you from a rise in the price of shares that you plan to purchase. This is called hedging.
Earn money on shares that are lying idle - If you want to gain advantage from the shares that you are holding from a long term, you can use derivative instruments to earn from the price fluctuations from those shares without selling the shares. Because derivatives market allows you to conduct transactions without actually selling your shares – also called as physical settlement.
Transfer of risk – Derivatives offers you the biggest advantage that allows you to transfer the market risk to enhance safety. There are a wide variety of products available and strategies that can be constructed, which allow you to pass on your risk. You can transfer risk from investors who have less potential of suffering risk to investors who have more potential for facing risk.
Benefit from arbitrage- When you buy low in one market and sell high in the other market, it called arbitrage trading. Simply put, you are taking advantage of differences in prices in the two markets.
Who are the participants in derivatives markets ?
There are four different types of traders in the market which are categorized on the basis of their trading motives. These are called as market participants namely; hedgers, speculators, margin traders and arbitrageurs. Let's take a look at how these participants trade in derivatives and how their motives are driven by their risk profiles.
just like we discussed about hedging, traders who want to protect themselves from the risk involved in price movements engage in the derivatives market. They are called hedgers. This is because they try to hedge the price of their assets by undertaking an exact opposite trade in the derivatives market. Thus, they pass on this risk to those who are willing to bear it.
A hedger passes on their risk to someone who is willingly take on risks. But why would someone do that? There are all kinds of participants in the market. Some might be not willing to take risk, while some people might enjoy it. This is because, speculators believe in the basic market idea that “the risk and return always go hand in hand.” Higher the risk, greater is the chance of high returns. This differences in risk profile and investment strategy differentiates hedgers from speculators. In the Indian markets, there are two types of speculators – day traders and the position traders. A day trader is the one who wants to take advantage of intra-day fluctuations in prices. All their trades are settled by undertaking an opposite trade by the end of the day. They do not keep their trade exposed to the market overnight. On the other hand, position traders take their decisions based on news, tips and technical analysis .they take and carry position for overnight or a long term.
Many speculators trade using of the payment mechanism unique to the derivative markets. This is called margin trading. When you trade in derivative products, you are not required to pay the total value of your position up front. . Instead, you are only required to deposit only a fraction of the total sum called margin. With a small deposit, you are able to maintain a large outstanding position. The leverage factor is fixed; there is a limit to how much you can borrow. The speculator can buy three to five times the quantity than his capital investment. This is how you either pay this outstanding position or conduct an opposing trade that would nullify this amount.
Derivative instruments are valued on the basis of the underlying asset’s value in the spot market. However, there are times when the price of a stock in the cash market is lower or higher than it should be, in comparison to its price in the derivatives market. Arbitrageurs exploit these imperfections and inefficiencies to their advantage. Arbitrage trade is a low-risk trade, where a simultaneous purchase of securities is done in one market and a corresponding sale is carried out in another market. These are done when the same securities are being quoted at different prices in two markets.
What are the different types of derivative contract ?
There are four types of derivative contracts – forwards, futures, options and swaps. However, for the time being, let us concentrate on the first three. Swaps are complex instruments that are not available for trade in the stock markets.
Futures and forwards: Futures are contracts that represent an agreement to buy or sell a set of assets at a specified time in the future for a specified amount.
Forwards are futures, which are not standardized: They are not traded on a stock exchange or example, in the derivatives market, you cannot buy a contract for a single share. It is always for a lot of specified shares and expiry date. This does not hold true for forward contracts. They can be tailored to suit your needs.
Options: These contracts are quite similar to futures and forwards. However, there is one key difference. Once you buy an options contract, you are not obligated to hold the terms of the agreement. This means, even if you hold a contract to buy 100 shares by the expiry date, you are not required to. Options contracts are traded on the stock exchange.
Swap: swap refers to an exchange of one financial instrument for another between the parties concerned. A swap is a contract which is based on a derivative which allows two parties to exchange their cash flows and liabilities from more than one fiscal instruments.
If you’re a beginner at derivatives trading, you might want to read more about options trading.
How to trade in futures ?
Futures represent a agreement to buy or sell a specific quantity of stock, security or commodity at a set price on a specified date in future. There are two parties to this contract, future buyer and future seller.
Future buyer - The buyer of a future contract gets the obligation to buy and receive the underlying assets when the future contract expires.
Future seller - The future seller is the one who sells the future contract taking an obligation to provide and deliver the underlying asset at the expiration date.
How to trade in options ?
Thus, buying stock futures and options contracts is similar to buying shares of the same underlying stock, but without taking delivery of the same. An option is a contract that gets the right but not the obligation to buy or sell the underlying asset at a particular strike price on or before the expiry of the contract.
Call buyer and put seller - Buying a call and selling a put denotes that a trader is bullish (rise in price) on the market. Hence, a call buyer buys a call option expecting a rise in the price over a period of time. On the other hand, the put seller sells the option earning a premium against it.
Call seller and put buyer - Selling a call and buying a put denotes that a trader is bearish (fall in price) on the market over a period of time. Selling a call means you sell it first and buy later. And on the other hand, buying a put means you buy it hoping its price to fall in the near future.
What are future derivatives?
The definition of derivative told us how it is a contract. Well, one can trade in many types of derivative contracts.
Firstly, there are futures. These are derivative contracts or agreements between the two parties to either buy or sell a fixed quantity of an asset at a particular time in the future for a fixed price. Most of the futures contracts are cash settled, which means only the cash differential is paid out. The 'lot size' specifies the minimum quantity that you will have to transact in a futures contract. Also, the contract value of a futures contract agreement is the 'lot size' multiplied by the price.
In a futures contract agreement, both the parties involved will have to deposit some money as a token advance required for entering into an agreement. The money has to be deposited with the broker. This initial money is a percentage of the contract value, and is called the 'margin amount'. Lastly, every futures contract has an expiry date - beyond which the contract would cease to exist. Upon the expiry of old contracts, new futures contracts are created.
What is FII Derivative?
Foreign institutional investors (FIIs) are crucial players in the futures & options (f& o) segment.
F& o trades or derivative trades have become lead indicators for the market. Apart from looking at the levels, traders see when FIIs are long with huge positions. This is because any small negative news leads to unwinding and vice versa.
An unwinding of long positions in f& o puts pressure on the cash market even if there is no actual selling happening in a big way. FIIs in derivatives also lead to arbitrage in the cash market.
FIIs with a strong back- up of significant holding in most index heavyweights often raise their play in the f& o segment.
What are the requisites to invest ?
As said earlier, trading in the derivatives market is very similar to trading in the cash segment of the stock markets. Trading in the derivatives market is a lot similar to that in the cash segment of the stock market. This has three main requisites:
Demat account: to trade in derivatives you need to create a demat account. This is the account which stores your securities in electronic format. It is unique to every investor and trader.
Trading account: this is the account through which you conduct trades. The account number can be considered your identity in the markets. This makes the trade unique to you. It is linked to the demat account, and thus ensures that your shares go to your demat account.
Margin maintenance: you need to maintain a minimum margin amount in your account for derivatives trading. While many in the cash segment too use margins to conduct trades, this is mainly used in the derivatives segment. Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required to deposit only a percentage of the value of your outstanding position with the stock exchange, irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money. You are expected to deposit the initial margin upfront. How much you have to deposit is decided by the stock exchange.
Go, get started!
Now that you know how to learn derivatives trading have fed your curiosity, below are the few steps you need to follow to get started with derivatives trading.
First do your research - This is more important for the derivatives market. However, remember that the strategies need to differ from that of the stock market.
Arrange for the requisite margin amount - This means, you need to maintain a minimum amount in your margin account and you cannot withdraw this amount from your trading account at any point in time until the trade is settled. Also remember that the margin amount changes as the price of the underlying stock rises or falls. So, always keep extra money in your account.
Conduct the transaction through your trading account - You will have to first make sure that your account allows you to trade in derivatives. If not, consult your brokerage or stock broker and get the required services activated. Once you do this, you can place an order online or on phone with your broker.
Select your stocks and its contracts on the basis of the amount you have in hand, the margin requirements, the price of the underlying shares, as well as the price of the contracts. Yes, you do have to pay a small amount to buy the contract. Ensure all this fits your budget.
You can wait until the contract is scheduled to expire to settle the trade - In such a case, you can pay the whole amount outstanding, or you can enter into an opposing trade. For example, you placed a ‘buy trade’ for Infosys futures at Rs.3,000 a week before expiry. To exit the trade before, you can place a ‘sell trade’ future contract. If this amount is higher than Rs. 3,000, you book profits. If not, you will make losses.
We covered top 10 important things that you must know before derivatives trading. It might have given a basic understanding of derivatives trading. You might be interested in starting your journey as derivative traders. But do remember, there is need for derivatives traders to be cautious while trading.