Derivatives Trading: What Are They and How Do They Work?

The financial markets are filled with all kinds of wealth building instruments, but perhaps one of the most versatile and dynamic could be derivatives. If you are an investor who is starting out or looking to learn more about investing, being able to learn how derivatives work will be integral in making your way around the financial world. This article shall look at what a derivative is, how it works, and why it’s indispensable in modern markets.

What Are Derivatives?

A derivative is a financial contract whose value is derived from the performance of an asset such as a stock, bond, commodity or currency. Rather than owning the asset itself, derivative traders speculate on the future price movement of these assets. This can be used for hedging purposes, to manage risk, or for speculative trading to gain profits.

Key underlying assets for derivatives include:

• Equity derivatives (stocks)
• Currency derivatives (foreign exchange)
• Commodities derivatives (gold, oil, etc.)

In essence, a derivative is an agreement between two parties that settles based on the future value of an underlying asset.

For derivative trading, Demat account opening online is essential through a registered stockbroker.

Types of Derivatives

There are many types of derivatives in the derivatives market, the most common are:

1. Futures Contracts: These are agreements to buy or sell an asset at a predetermined price in the future. Futures trading in derivatives is popular among investors looking to profit from or hedge against future price movements.
2. Options Contracts: These give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price before the contract expires.
3. Forwards: Similar to futures, but these are private contracts and typically traded over-the-counter (OTC).
4. Swaps: This is an agreement between two parties to exchange cash or other financial instruments.

What Is Derivatives Trading?

Derivative trading or futures and options trading  involves buying and selling these contracts based on the future price movements of an underlying asset. For instance, derivative trading in the stock market allows investors to speculate on the future value of stocks, which can be advantageous during both rising and falling markets.

One key advantage of intraday trading in derivatives is that it allows investors to profit from price movements throughout the day without holding the underlying asset. However, trading in derivatives can also carry significant risks due to the leverage involved.

What Is the Derivatives Market?

The derivatives market is where these contracts are bought and sold. It’s divided into two main segments:

1. Over-the-Counter (OTC) Market: Private, bilateral contracts traded between two parties without central regulation.
2. Exchange-Traded Market: Standardized contracts like futures and options traded on regulated exchanges such as the Chicago Mercantile Exchange (CME) or the National Stock Exchange (NSE) in India.

The derivatives segment is essential for providing liquidity, reducing risk, and enabling price discovery for the underlying assets. Investors use this market to hedge, speculate, and diversify their portfolios.

Physical Delivery and Cash-Settled Derivatives

Derivatives may involve delivery or cash payments:

• Physical delivery: The underlying asset is actually delivered upon the expiration of the contract. For example, in a futures contract for oil, barrels of oil might be physically delivered.
• Cash-settled derivatives: Instead of delivering the actual asset, the difference between the contract price and the asset’s market price is settled in cash.

Why Trade Derivatives?

There are several reasons why investors choose to engage in derivative trading:

1. Hedging: Protection against losses resulting from adverse price movements in assets.
2. Speculation: Taking a position in the market with the aim of making a profit from price fluctuations.
3. Leverage: Derivatives allow traders to control large positions with relatively little capital, potentially increasing the return on investment.
4. Diversification: Derivatives can provide exposure to different types of assets without the need to own them directly.

How to Do Derivatives Trading?

To start learning derivatives trading, follow these steps:

1. Understand the basics: Begin by studying what are derivatives and how they function. Use reliable sources and educational platforms.
2. Choose a Derivatives App: Opt for a trusted platform like HDFC Sky. This trading app offers tools and resources to help you trade derivatives in a user-friendly environment.
3. Select the Type of Derivative: Based on your investment strategy, choose between equity derivatives, currency derivatives, or commodity derivatives.
4. Open a Trading Account: Sign up with a brokerage that offers derivative brokerage services. Ensure they provide access to the derivatives segment.
5. Develop a Strategy: Decide whether you want to hedge or speculate, and plan your trades accordingly.
6. Monitor Market Trends: Stay up to date on the latest financial news and business trends so you can make informed decisions.

What Is Margin in Derivatives Trading?

When trading derivatives, traders often use margin, the amount of money required to open a leveraged position. Margin in derivatives trading enables investors to control large market positions with a fraction of the asset’s value. However, it also increases the risk of significant losses, as positions can be liquidated if the market moves against the trader.

• Initial margin: The least amount required to open a position.
• Maintenance margin: The minimum balance that must be maintained in the account to keep a position open.

Charges and Taxes on Derivatives

When trading derivatives, traders are subject to certain fees and taxes, such as:

1. Brokerage fees: Charged by brokers for facilitating trades in the derivatives market.
2. Transaction charges: Applied by exchanges for each trade conducted.
3. Securities Transaction Tax (STT): Applicable on the sale of certain derivatives, such as futures and options.
4. GST: Goods and Services Tax (GST) may be applicable to the services provided by the brokerage.
5. Stamp duty: Applicable on the notional value of the contract at the time of trade.

It is important to understand these costs as they impact your overall profitability when engaging in derivatives trading in stock market.

Conclusion

In conclusion, derivatives offer investors a unique way to speculate, hedge, and diversify their portfolios. Whether you’re trading equity derivatives, currency derivatives, or other types of derivatives, it’s crucial to understand the risks and benefits involved. By choosing a reliable platform like HDFC Sky, you can gain access to the share market derivatives and develop your skills in this exciting financial segment. Remember to start small, focus on learning derivatives trading, and gradually build your knowledge to succeed in this complex but rewarding market.