What is Derivatives Trading

Stock market and speculation are almost synonymous. Many believe that stock market trading is speculation. Some even call it a casino. Stock market prices today are a reflection of tomorrow’s prospects. They rise and fall in tandem with profits of businesses. Indians love to speculate.

The market was introduced to modern ‘derivatives’ trading recently. Stock futures and options or derivatives are used extensively in India for speculation.

Here are five things you need to know about derivatives trading:

1) What are they: A derivative is a security that derives value from an underlying asset. An underlying asset could be an equity share, debt instrument, a currency or a commodity. Derivatives deal with an agreement to trade at a future date or at a certain price.

2) Types of derivatives: There are two types of derivative instruments. Futures and options. Futures allow you to bet on future trends in prices of an underlying instrument at a fraction of the cost of that instrument. Options give you an option to buy or sell the stock, commodity or a debt instrument at a target price. If the price of a stock is Rs 100, you expect it to go up to Rs 110 in a month’s time, then you buy a contract at Rs 100 today and agree to sell it at Rs 110 at the end of the month.

3) Why derivatives: There are many advantages of derivatives trading. Most use it to hedge their losses or safeguarding their investments from fluctuations in the market. So if you have bought Reliance Industries shares and suddenly due to an external event not related to Reliance Industries its share price is likely to fall, you could use derivatives to sell Reliance stock futures and hedge your loss in the equity market. Importers and exporters often hedge their currency risk.

So when they import goods, they pay in foreign exchange. If the rupee value falls against the US dollar, imported goods get expensive. Hedging in currency derivatives helps in cutting these losses. Traders also use the secondary market for arbitrage – buy cheap in one market and sell at a higher price in another or vice versa. There is always a price difference in markets.

4) How do I start: Derivative instruments are available with registered trading members of stock exchanges like brokerage firms. You will have to fill the Know Your Client (KYC) form if you are a first time investor, along with other forms for purchasing the contract you wish. You are allotted a client identification number, after which you must deposit cash to initiate trade.

5) How it works: Trading is a simple ‘buy and sell’ process. The only difference is that you will not have to pay the entire sum, but just a margin. For example, if you are buying 100 contracts of Nifty 50 October futures with a value of 5000, and if the margin is 5%, then you don’t have to pay Rs 5,00,000, but just Rs 25,000. All such transactions are settled at the end of every trading day. Investors are not required to hold any stock of the underlying asset for trading in the derivatives market.