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While most people understand what stock trading means, the concept becomes harder to understand when derivatives get involved. Derivatives are financial products that rely on the prices of underlying assets, which in this case, are stocks.
The most common derivatives are options and futures, which are widely traded in the Indian stock markets. In this article, we’re going to dive deeper in those markets, explore them briefly, and understand how you can start trading in them.
Why would you use a derivative?
Straight stocks offer a simple way to invest: buy low, hope it goes high, sell and enjoy the profit. But they can be like roller coasters, leaving you hanging at their mercy. This is where derivatives come in, acting like seatbelts on that financial ride.
Derivatives don’t directly own stocks, but instead bet on their future movement. Imagine you own a bakery and worry about rising flour prices. With derivatives, you can “lock in” a future price for flour, protecting yourself from nasty surprises. Or, if you think a new tech stock will skyrocket, you can buy a derivative that has a big payoff, without needing to buy all the shares yourself.
So, in terms of investment, derivatives offer two main advantages: they shield you from risk (like that flour price) and let you capitalise on opportunities (like that tech stock) with more flexibility.
You have to beware of derivatives, however, because they are known to amplify your potential losses and gains. This is because of leverage, which means that you can make trades for more money that you have. For instance, if your broker offers you 10x leverage and you have ₹1,000 to trade, you can trade derivatives worth ₹10,000. This makes derivatives both more lucrative and more risky at the same time.
This is the reason why they should be used strategically with certain risk controls in place.
Options are a very common kind of derivative. With options, you could set the price for which you’d like to either sell or buy the underlying asset. Once you have the right to sell or buy the asset (for which you pay a premium upfront), you have the option to execute that trade, not the obligation.
For instance, if Stock X is priced at ₹22 right now, you could buy an option to buy Stock X when it hits ₹25 per share. This is a call option. When prices go up in, say 6 months, and the stock is worth ₹30 now, you still have the right to buy at ₹25. As soon as you do that, you could sell for ₹30 in the market. The same goes for selling stocks too.
The right to buy a stock at a future price is called a call and the right to sell in the future is called a put. In a brokerage where you buy options, you will typically see both these options priced next to each other.
However, these options don’t come free. You have to pay a premium whenever you buy an option and they could be cheap or expensive depending on market conditions and its future outlook.
Like we said before, you don’t have to buy Stock X at ₹25 if prices go further down, for instance. If prices are at ₹15 after you buy the option, you’d lose money if you execute it. So you don’t. You just end up losing the premium you paid while buying the call option, but no more.
Futures are a bit more risky. The concept remains the same – you agree to buy or sell an asset at a future date but decide the price today. However, with futures, there are some changes.
- Leverage – Futures trading usually requires leverage, which means that you have to buy a lot of futures to actually trade them. Usually, the amount you buy depends on what the asset’s lot size is. So you have to have more skin in the game to trade in options.
- Mark-to-market – Futures are priced mark-to-market, which means that your position will be dynamic every day. Every single day, you’re either going to be down some money or up some money, and the numbers will change every day.
- Margin – You will also be required to post margin, which is the minimum amount of money your exchange or broker will charge you to mitigate risk. This will be refunded to you when the trade is closed, but if you lose money and your margin falls below the requirement, you’ll have to deposit more.
With futures, there is an obligation to buy or sell at the price that you decide, no matter how much money you’re losing. While you have the option to close your position if it goes below what you can tolerate, there is no limit to which you can lose money – it could be infinite. This is what makes futures more risky than options.
The derivatives market around the world is said to be worth more than a quadrillion U.S. dollars, which is a lot of money. Since derivatives amplify both losses and gains, the derivatives market is worth several times more than the market for the underlying assets.
We encourage you to do your own research, practice paper trading before getting real money involved, and start small when trading derivatives. Good luck!
Frequently Asked Questions
The derivative market is a marketplace where contracts get their value from an underlying asset (e.g., stocks, bonds, commodities, currencies). These contracts are not bought or sold like the underlying asset itself; instead, they represent an agreement between two parties about the future performance of that asset.
Futures: Binding contracts to buy or sell an asset at a predetermined price on a future date.
Options: Grant the right, but not the obligation, to buy or sell an asset at a set price by a certain date.
Forwards: Similar to futures but traded over-the-counter (OTC).
Swaps: Agreements to exchange cash flows based on different variables.
Stocks: Represent ownership in a company, offering dividends and potential capital appreciation.
Derivatives: Do not represent ownership; they are contracts based on the expected future performance of an asset. They offer:
Leverage – Magnify potential gains/losses for smaller investments.
Hedging – Manage risk by offsetting existing positions.
Speculation – Profit from predicted price movements.
Risk management: Can be used to hedge existing positions to mitigate potential losses due to price fluctuations.
Price discovery: Derivatives help efficient price discovery for underlying assets through speculation and competitive trading.
Capital efficiency: They also enable access to various markets and leverage existing positions without large upfront investments.
Complexity: Derivatives can be difficult to understand and involve unique risks due to leverage and counterparty exposure.
Potential for loss: They are highly leveraged instruments that are susceptible to significant losses if market movements contradict predictions.
Regulation: Subject to complex regulations, requiring careful due diligence and professional guidance.