WHAT ARE DERIVATIVES

Derivatives are financial contracts that derive their

value from an underlying asset. These could be
stocks, indices, commodities, currencies, exchange
rates, or the rate of interest. These financial
instruments help you make profits by betting on the
future value of the underlying asset. So, their value
is derived from that of the underlying asset. This is
why they are called ‘Derivatives’.
• Earn money on shares that are lying idle
• So you don’t want to sell the shares that you bought for the
long term, but want to take advantage of price fluctuations
in the short term. You can use derivative instruments to do
so. The derivatives market allows you to conduct
transactions without actually selling your shares - also called
physical settlement.
• Benefit from arbitrage
• When you buy low in one market and sell high in the other
market, it is called arbitrage trading. Simply put, you are
taking advantage of differences in prices in the two markets.
• Examples of Arbitrage
• As a straightforward example of arbitrage,
consider the following. The stock of Company X
is trading at $20 on the New York Stock Exchange
(NYSE) while, at the same moment, it is trading
for $20.05 on the London Stock Exchange (LSE).
• A trader can buy the stock on the NYSE and
immediately sell the same shares on the LSE,
earning a profit of 5 cents per share.
 History of the Derivative

• The derivative has a long and colorful history. The term ‘derivative’ was
first used in the early 18th century to describe a financial instrument
that allowed two traders to offset their risks.
• The derivative later became a key part of the global financial system,
and has played an important role in economic development. Today,
derivatives are widely used in both commodity and security markets.
• The derivative market is vast and complex. It consists of contracts that
allow investors to hedge their risks by transferring them from one
investment to another.
• Derivatives can be divided into two main categories: over-the-counter
(OTC) contracts and exchange-traded contracts (ETCs). OTC derivative
are traded between individuals, while ETCs are traded on exchanges.
 Advantages of Derivative Trading

• Arbitrage advantage
• You can have an arbitrage advantage by
buying a commodity at a cheap price in one
market and selling it at a higher price in
another market. By doing so, you can reap
from the varying prices of commodities in two
different markets. In addition, they help to
decipher underlying asset prices..
• Hedging risk
• With these contracts, you can evade risk. Most times,
during trading, risks are likely to rise out from
fluctuations in price movement.
• Low transaction cost
• These contracts bring about low transaction costs,
which are useful to every investor. Compared to other
securities, like shares and debentures, the cost of
trading is lower. It operates as a risk management tool
and helps to protect prices from fluctuations.
 Disadvantages

• Requires expertise
• A major setback is a lack of experience. Any
investor who seeks to trade needs a high
knowledge and experience level on how
trading works. Hence, it's important to
remember derivatives are not the same as
securities like stocks.
• Speculative features
• You can make speculations for earning profits.
But with this speculation, errors are likely to
occur, thereby causing huge losses. This
method can be risky and unpredictable when
some features are not speculated well
enough, so the loss may be massive.
• Exposure to high risk
• As they are traded in the open market, prices
of underlying securities keep on fluctuating.
There is exposure to high risk as a result of
highly unstable prices of underlying securities.
 DERIVATIVE TRADING

WHO ARE THE PARTICIPANTS IN DERIVATIVES MARKET

• Hedgers: Traders, who wish to protect
themselves from the risk involved in price
movements, participate 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
• For example, let's say that you possess 200 shares of a company – ABC Ltd. and
the price of these shares is hovering at around Rs. 110 at present. Your goal is
to sell these shares in six months. However, you worry that the price of these
shares could fall considerably by then. At the same time, you do not want to
liquidate your investment today, as the stock has a possibility of appreciation
in the near term.
• You are very clear about the fact that you would like to receive a minimum of
Rs. 100 per share and no less. At the same time, in case the price rises above
Rs. 100, you would like to benefit by selling them at a higher price. By paying a
small price, you can purchase a derivative derivative contract called an 'option'
that incorporates all your above requirements. This way, you reduce your
losses, and benefit, whether or not the share price falls. You are, thus, hedging
your risks, and transferring them to someone willing to take these risks.
• Speculators: As a hedger, you passed on your risk to someone
who will willingly take on risks from you. But why would
someone do that? There are all kinds of participants in the
market.
• Some might be averse to risk, while some people embrace them.
This is because the basic market idea is that risk and return
always go hand in hand. The higher the risk, the greater the
chance of high returns. Then again, while you believe that the
market will go up, there will be people who feel that it will fall.
These differences in risk profile and market views distinguish
hedgers from speculators. Speculators, unlike hedgers, look for
opportunities to take on risk in the hope of making returns.
• Let's go back to our example, wherein you were keen to sell the 200
shares of company ABC Ltd. after one month, but feared that the
price would fall and eat your profits. In the derivative market, there
will be a speculator who expects the market to rise. Accordingly, he
will enter into an agreement with you stating that he will buy shares
from you at Rs. 100 if the price falls below that amount. In return
for giving you relief from this risk, he wants to be paid a small
compensation. This way, he earns the compensation even if the
price does not fall and you wish to continue holding your stock.
• This is only one instance of how a speculator could gain from a
derivative product. For every opportunity that the derivative market
offers a risk-averse hedger, it offers a counter opportunity to a
trader with a healthy risk appetite.
• Margin traders: Many speculators trade using 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. This is why
margin trading results in a high leverage factor in
derivative trades. With a small deposit, you can
maintain a large outstanding position.
• Arbitrageurs: Derivative instruments are valued based on
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.
• In the earlier example, suppose the cash
market price is Rs. 1000 per share but is
quoting at Rs. 1010 in the futures market. An
arbitrageur would purchase 100 shares at Rs.
1000 in the cash market and simultaneously,
sell 100 shares at Rs. 1010 per share in the
futures market, thereby making a profit of Rs.
10 per share.
• Derivatives can be classified as:
• 1. Commodities derivatives: These are derivatives on
commodities like sugar, jute, paper, gur, castor
seeds.
• 2. Financial Derivatives: These derivatives deal in
shares, currencies and gilt-edged securities.
• 3. Basic Derivatives: Futures and Options are basic
derivatives.
• 4. Complex Derivatives: Interest rate futures and
swaps are classified as complex derivatives.
• 5. Exchange traded derivatives are standard
contracts traded according to the rules and
regulations of a stock exchange. Only members can
trade in exchange traded derivatives and they are
guaranteed against counter-party default. Contracts
are settled daily.
• 6. OTC Derivatives are regulated by statutory
provisions. Swaps, forward contracts in foreign
exchange are usually OTC derivatives and have a
high risk of default.
WHAT ARE THE DIFFERENT TYPES OF DERIVATIVE CONTRACTS
 The 4 Types of Derivative Securities

• 1. Options
• Options are contracts that grant their owners the right (but
not the obligation) to purchase or sell a specific security for a
specific strike price on or before a specific expiration date.
Put options give their owners the right to sell something, and
call options give their owners the right to buy something.
• The price an option buyer pays an option seller (sometimes
referred to as an option writer) for an options contract is
called a premium. An option’s premium depends on its strike
price, the amount of time remaining until its expiry, and the
volatility of the underlying asset.
• 2. Futures
• A futures contract obligates its buyer to purchase—and its seller to
sell—a specific quantity of a particular security (often a commodity
like corn or crude oil) at a predetermined price (usually the current
market value of the security) on a particular date in the future. In
other words, futures contracts allow buyers and sellers to “lock in”
the current price of an asset for a future date.
• If an investor speculates that oil prices will rise over the next six
months, they might buy a futures contract that obligates them to
purchase X barrels of crude at today’s price six months from now. If
the price of oil does go up, they can either sell the contract to another
buyer for a higher premium or wait until the contract’s expiration and
take possession of the barrels at the now-discounted price.
• Let’s understand it with a simple futures contract
example:
• Luther started a company that consistently requires
silver, and his company is already in conversation with a
company supplying silver. The silver provider uses a
futures contract to bind Luther and his company,
promising to sell a fixed quantity of silver at a pre-
determined price and the time the delivery will be
executed. Luther agrees to the contract. Now both of
them are obligated to trade the silver in the future at a
set price.
• Examples
• The below example will help you understand futures
contracts better:
• Mr. X expects the oil price to rise before May. Currently,
the oil contract for May is selling for $60. So, Mr. X buys
one contract (of 1,000 barrels). Now, if near the expiry,
the oil price rises to $65, Mr. A will make a profit of
$5,000 [($65 less $60 * 1000]. And, if the oil price drops
to $55, Mr. A would incur a loss of $5,000 [($ 60 – $55) x
1000].
• The above example was involving a speculator.
• Let us consider another example, but this time of hedging.
• A producer is planning to produce a million barrels of oil in six
months. Or, the oil would be ready for delivery in six months. The
current oil price is $50, and the producer is okay selling the oil at
this price. However, the price could change a lot in the six months.
• If the producer expects the prices to rise in the future, then he
would not want to lock the price. But, if he believes the price to
drop, then he would want to lock the price by using a futures
contract.
• Now, assume the cost of a six months oil futures contract is $53. By
entering the contract, the producer will have an obligation to
deliver one million barrels of oil at $53.
• 3. Forwards
• Forward contracts are similar to futures in that they
are agreements between two parties to buy/sell a
specific asset for a predetermined price on a
specific date. They differ from futures, however, in
that they are not standardized—the terms of each
contract are negotiated and determined by the
parties involved. For this reason, they are traded
only on the over-the-counter market—not on
public exchanges.
• Example of a Forward Contract
• Suppose you are a farmer and you want to sell
wheat at the current rate of Rs. 18, but you
know that wheat prices will fall in the coming
months ahead. In this case, you enter a
contract with a grocery for selling them a
particular amount of wheat at Rs. 18 in three
months
• 4. Swaps
• A swap is a customized derivative contract
through which two parties agree to exchange
the payments or cash flows from two assets at
a set frequency for an agreed-upon period of
time.
 Types Of Swaps

• Interest Rate Swaps: The idea behind an

interest rate swap is to switch the cash flows
from a fixed interest rate to a floating interest
rate. In such a swap, Party A agrees to pay a
fixed rate of interest to Party B on a notional
principal for a specified period and on
predetermined intervals.
• Total Returns Swap: In total returns swaps, the total return from a
particular asset is swapped for a fixed interest rate. The party that
pays the fixed rate takes on the exposure towards the underlying
asset, be it a stock or an index. For instance, an investor can pay a
fixed rate to a party in return for exposure to stocks, realising the
capital appreciation and earning the dividend payments, if any.
• Commodity Swaps: Commodity swaps are used to exchange cash
flows that are dependent on a commodity price. As the price of
commodities is floating, one party exchanges this floating rate for a
fixed rate. For example, a producer can swap the spot price of
Brent Crude oil for a price that is set over an agreed-upon period. It
allows producers to lock in a set price and mitigate losses based on
future price fluctuations.
• Debt-Equity Swaps: A debt-equity swap involves the swapping of
equity for debt and vice versa. It is a financial restructuring
process where one party exchanges/cancels another party’s debt
in exchange for an equity position. For a publicly-traded company,
this would mean exchanging bonds for stocks. Debt-equity swaps
are a means for a company to refinance its debt as well as
relocate its capital structure.
• Credit Default Swap (CDS): CDS or credit default swaps is an
agreement by a party that offers insurance to the second party if
a third party defaults on a loan offered by the second party. The
first party offers to pay the principal amount that is lost as well as
the interest on a loan to the CDS buyer, provided the borrower
defaults on their loan.
• Currency Swaps: In a currency swap, both parties exchange principal
and interest payments on debt that is denominated in different
currencies agreed by the parties. Unlike an interest rate swap, the
principal is often not a notional but is exchanged along with interest
obligations. Currency swaps can take place between different countries.

Consequently, Party B agrees to make payments to Party A on a floating

interest rate with the same notional principal, the same amount of time,
and the same intervals. The same currency is used to pay the two cash
flows in a classic interest swap, otherwise known as a plain vanilla
interest swap. The predetermined payment dates are known as
settlement dates, and the time between them is called the settlement
period. As swaps are customised contracts, payments can be made
monthly, quarterly, annually, or at any interval determined by the parties
HOW TO TRADE IN DERIVATIVES MARKET
• 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. For example, you
may wish you buy stocks that are likely to rise in the future. In
this case, you conduct a buy transaction. In the derivatives
market, this would need you to enter into a sell transaction. So
the strategy would differ.
• 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 stockbroker 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 their contracts based on 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.
• Thus, buying stock futures and options contracts is similar to buying
shares of the same underlying stock, but without taking delivery of the
same. In the case of index futures, the change in the number of index
points affects your contra
 WHAT ARE THE PREREQUISITES TO INVEST

• Demat account:This is the account that stores your securities in

electronic format. It is unique to every investor and trader. Opening a
Demat account should be pretty simple if you don't have one already.
• 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. Click here if you want to open a trinity account that relieves
you from the hassles of operating different Demat, trading, and
savings bank accounts.
• Margin maintenance: This prerequisite is unique to derivatives
trading. While many in the cash segment use margins to conduct
trades, this is predominantly used in the derivatives segment.
• You are expected to deposit the initial margin upfront. How much you
have to deposit is decided by the stock exchange.
• It is prescribed as a percentage of the total value of your outstanding
position. It varies for different positions as it takes into account the average
volatility of a stock over a specified time period and the interest cost. This
initial margin is adjusted daily depending on the market value of your open
positions.
• The exposure margin is used to control volatility and excessive speculation
in the derivatives markets. This margin is also stipulated by the exchanged
and levied on the value of the contract that you buy or sell.
• Besides the initial and exposure margins, you also have to maintain Mark-
to-Market (MTM) margins. This covers the daily difference between the
cost of the contract and its closing price on the day of purchase. Thereafter,
the MTM margin covers the differences in closing price from day to day.