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In its simple form derivatives means an entity that derives its value from another entity. It holds a similar meaning in the context of the stock market. The answer to the question, what is derivatives in stock market? is that Derivative is a financial instrument that derives its value or price based on the underlying entity or asset. The value of derivatives depends on the underlying asset or group of assets. For example, Petrol and Diesel are made from Crude oil. Therefore, Petrol and Diesel are derivatives of Crude oil. In this blog, we are going to cover all the details about derivatives in share market.
This Blog covers,
What is derivatives in share market?
Types of derivatives in stock market
Prerequisites for derivative trading in India
How to trade Derivatives in Indian stock market
What are the risks in derivatives in share market you should be aware of?
Conclusion
What is derivatives in share market?
Derivatives are essentially financial contracts that derive their value from an underlying entity or asset. The underlying asset can be any of the stocks, commodities, currencies, indices, exchange rates, or even interest rates. Buying and selling of these contracts are referred to as derivative trading in India. With derivatives, you can make profits by predicting the future price movement of the underlying asset.
The commonly used assets are stocks, bonds, currencies, commodities, and Market Indices. The value of the underlying assets keeps changing according to market conditions.
The Basic principle behind entering into derivative contracts is to earn profits by speculating on the value of the underlying asset in future.
Let us understand derivatives in share market with a better example,
Let’s say, a farmer, who produces wheat, expects to sell 10 Quintal of wheat after
4 months at Rs. 2000 per quintal. But he is afraid of some damage due to untimely rain predictions. To avoid the risk, he approaches a commodities broker and enters into a contract to sell his 10 Quintal wheat production after four months at Rs. 2000. Therefore, tomorrow if the prices fall to Rs. 1970 due to large supply in the market, the broker will be bound to pay Rs. 2000 to the farmer. But after four months, if the market price of wheat rises to Rs. 2020, the farmer ends up losing Rs. 20 per quintal as he is bound to sell at Rs. 2000 to the broker. This transaction very simply explains how a derivative contract works!
It is an example of a forward contract which also is one of the types of derivatives in stock market where the underlying asset is a commodity. If you want to enter derivative trading in India then you should know everything about derivatives. Now that you know what is derivatives in stock market? let’s move ahead to its types.
Types of derivatives in stock market
There are basically he four major types of derivative contracts,
Forwards
Futures
Options
Swaps
Let us take you through each of the types of derivatives in stock market,
1. Forwards and Futures
These financial contracts obligate the buyers to purchase an asset at a pre-agreed price on a specified future date. Forwards are customized contracts and they are not traded anywhere.
2. Futures
These financial contracts obligate the buyers to purchase an asset at a pre-agreed price on a specified future date. The nature of forwards and futures contracts is same. The major difference is that futures are traded on the Exchanges.
3. Options
Options provide the buyer of the contracts the right but not the obligation to purchase or sell the underlying asset at a predetermined price. There are two types of options,
Call option
In a call option, you have a right but not the obligation to buy a given quantity of an underlying asset at a given price.
Put Option
In a put option, you have a right but not the obligation to sell a given quantity of underlying commodity/asset at a given price.
To buy any kind of option, you have to pay a premium.
4. Swaps
Swaps are the types of derivatives in stock market derivative contracts that allow the exchange of cash flows between two parties. Interest rate swaps, commodity swaps, and currency swaps are some of the most popular types of swaps.
Mark to Market
This is the vital term in derivatives in share market. Mark to Market, involves recording the price or value of a security to reflect the current market value rather than just the book value. It is also known as M2M and is mostly done in the futures market. Now among these four types of derivatives, only futures and options are traded on the stock exchange. If you want to know everything about futures and options trading then you can read our expert-written blog on
What are the benefits of derivative trading in India?
1. Hedging risk exposure
Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. Hedging risk means reducing risk in one investment by making another investment. An investor takes opposite positions in two investments to offset the risk of any adverse price movements.
2. Underlying asset price determination
Spot derivatives are frequently used to determine the price of the underlying asset in derivatives trading in India. For example, the spot prices of the futures can serve as an approximation of a commodity price.
3. Higher Returns
Derivatives trading gives you more possibilities for higher returns.
What are the risks in derivatives in share market you should be aware of?
1. High Volatility
The high volatility of the derivatives exposes them to potentially huge losses.
2. Speculative Features
Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses. Derivative trading in India can be extremely beneficial but we suggest that you enter the derivatives market after you have had at least 5-6 years of experience in the stock markets.
How to trade Derivatives in Indian stock market
For derivatives trading, you should be aware about the following points,
1. Prerequisites
To start derivative trading you should have the following prerequisites,
An active DEMAT account
A trading account in India
A specific percentage of cash in your trading account to be able to trade in derivatives
To trade derivatives in Indian stock market you need to link your DEMAT account to your trading account. If you don't have a trading account then you can set up a trading account with any good broking firm.
2. Margin money
With the huge profit, derivative comes with a high risk. Therefore in derivative trading, it is mandatory for a derivative trader to hold a specific percentage of the value of their outstanding derivative position as cash in their trading account. This amount is referred to as 'margin money'. The trading of derivatives in Indian stock market is regulated by the Securities and Exchange Board of India (SEBI). The SEBI has set a certain margin limit to help minimize the risk exposure for the stock exchanges you’re trading on.