How to trade different types of derivatives in India

Many people invest their money in the stock market, hoping for good returns, but they might not realise the risks involved. Changes in the prices of securities like currency, stocks, and commodities can make trading in the stock market risky, and you could lose all your money in an instant.

Luckily, there are instruments that can protect you from these market fluctuations and provide some guarantees. These instruments are called derivatives. 

Derivatives are financial contracts whose value is derived from an underlying asset, index, or rate. Rather than representing ownership of the asset itself, derivatives enable traders to speculate on or hedge against changes in the price of the underlying asset. 

Some common types of derivatives include options contracts, futures, swaps, and forwards. They play a crucial role in financial markets by providing opportunities for risk management, speculation, and portfolio diversification.

Derivatives are widely used to navigate uncertainties in markets, allowing participants to protect against potential losses or capitalise on market movements without owning the actual underlying assets.

Now, let’s explore what are the types of derivatives traded in the Indian stock market.

Types of derivatives in India

There are basically 4 different types of derivatives market in India. These four different types of derivatives include:

• Forward Contracts
• Future Contracts
• Options Contracts
• Swap Contracts

Let’s have a detailed look at each of these types of derivatives.

1. Forward contracts

Forwards in India are customisable contracts where two parties agree to buy or sell an asset at an agreed price on a future date, directly negotiated between them. 

Unlike futures traded on exchanges, forwards are privately arranged, typically over-the-counter. They’re commonly used for hedging risks in commodities and currencies. 

For example, a farmer may agree to sell their crop to a buyer at a fixed price in the future, reducing the uncertainty of price fluctuations.

While forwards offer flexibility, they lack the standardised features and liquidity of exchange-traded futures, and their terms are tailored to each agreement’s specific needs.

2. Options contracts

Options contracts provide you with the right (but not obligation) to buy (call) or sell (put) a specific quantity of an asset at a predetermined price within a set timeframe. 

Traded on exchanges like NSE and BSE, options offer flexibility. Calls allow profit if the asset price rises above the strike price, while puts profit if the price falls below. 

Traders use options for various strategies, including hedging against price fluctuations or speculating on future market movements. 

Unlike futures, options offer the choice to execute or not, making them versatile tools for managing risk and capitalising on market opportunities.

3. Futures contracts

Futures contracts in India are like agreements where you agree to buy or sell something at a set price on a specific future date. 

Imagine you promise to buy rice at a fixed price in three months. If the price of rice goes up, you benefit because you still buy it at a lower price. But if the price falls, you’re still locked into the higher price. 

These contracts are traded on organised platforms, helping people manage risks or speculate on future price movements. They’re commonly used in commodities like wheat or gold and are crucial for businesses and traders to plan ahead securely.

4. Swaps

Out of the four derivatives, swap is the most complex one. Swaps are agreements between two parties to exchange cash flows or other financial instruments based on predetermined terms. They commonly involve interest rates or currencies. 

For instance, in an interest rate swap, one party may exchange a fixed interest rate for a variable one with the other party. Swaps help manage risks associated with interest rates and currencies, providing flexibility to participants. Corporations and financial institutions mainly use them to hedge against fluctuations in interest rates or currency values. 

Swaps facilitate customised risk management strategies, enabling parties to align their financial positions with their specific needs and preferences.

Who participates in the derivatives market?

India has two types of derivative markets: the exchanges-traded market and the over-the-counter (OTC) market. The Securities and Exchange Board of India regulates the derivative market in India. 

In India, there are various types of participants engaged in the derivatives market, contributing to its liquidity and functioning. These participants include:

1. Hedgers

Hedgers in the derivatives market are like insurance buyers. They’re usually businesses or individuals who want to protect themselves from price fluctuations. 

For example, a company might use derivatives to lock in prices for materials they need in the future, shielding them from unexpected price rises. Similarly, a farmer might hedge against price drops for crops. 

By doing this, they reduce the uncertainty of future costs or revenues, making their financial planning more stable and predictable.

2. Speculators

These are traders who aim to make profits by predicting price movements. Unlike hedgers who use derivatives to manage risks, speculators don’t necessarily have an underlying asset to protect. 

Instead, they take positions based on their expectations of future market movements. Speculators often buy or sell derivatives contracts, such as futures or options, in anticipation of capitalising on potential price changes. 

Their activities add liquidity and can contribute to market efficiency, but they also carry higher risks due to their speculative nature.

3. Arbitrageurs

Arbitrageurs exploit price differences between different markets to make profits with low risk. They buy securities at a lower price in one market and sell them at a higher price in another market where the same security is quoted at a different price. 

For example, if a stock is priced at Rs 1000 in the stock market and Rs 105 in the futures market, an arbitrageur would buy it for Rs 1000 and sell it for Rs 1050 in the futures market, earning a profit of Rs 50 with minimal risk.

4. Margin traders

Margin traders operate by trading only a fraction of the total contract value, known as margin, allowing them to leverage their positions. This means they can control larger positions with relatively smaller amounts of capital. 

Margin trading enables traders to amplify potential returns, but it also increases risk as losses can exceed the initial trades. 

Margin trading involves borrowing funds from brokers, with the margin serving as collateral, enabling traders to participate in the market with less capital upfront.

Conclusion

Understanding the various types of derivatives in India is crucial for traders to navigate the financial markets effectively.  Whether it’s futures contracts, options, swaps, or forward contracts, each type serves specific purposes and offers opportunities for managing risks and maximising returns. Explore more such content on trading instruments on StockGro. 

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