Derivatives Trading: Types, Advantages & Disadvantages, and factors

Derivative trading is a type of trading that involves contracts derived from underlying assets such as stocks, commodities, currencies, and more. Derivatives have become popular in India and have even surpassed the cash segment in terms of trading volume. Investing in derivatives can be highly profitable, but it’s important to have a thorough understanding of how they work before getting started. With derivative trading, investors can profit by predicting the future price movement of the underlying asset.

Derivatives trading allows traders to take long and short positions on various assets, including currencies, commodities, shares, indices, bonds, and interest rates. However, traders must fully understand derivatives markets and the different types of derivatives before trading.

Types of derivatives

Futures – A futures contract refers to a deal made between two parties where they agree to buy or sell an underlying asset in the future, at a price that is predetermined. This contract creates an obligation on both the buyer and the seller to fulfill the terms of the agreement on the specified future date, regardless of the market conditions. Futures contracts are commonly used by traders for speculation or hedging purposes, and they are traded on regulated exchanges.
Options – An options contract is a financial tool that provides the purchaser with the right, but not the obligation, to purchase or sell the underlying asset at a set price on or before a specific date. The individual who sells the option must sell or buy the underlying asset if the buyer decides to use the option. Options contracts are used for hedging and speculating and can be traded on exchanges or over-the-counter (OTC) markets.
Swaps – A swap is a financial agreement in which two parties agree to exchange cash flows according to a predetermined set of conditions. Swaps can involve the exchange of fixed or floating interest rates, currencies, commodities, or other financial assets. Unlike futures and options, swaps are not traded on exchanges, and they are typically used by institutional investors for hedging purposes. Swaps can be customized to fit the needs of the parties involved, and they are not standardized like future and options contracts.
Forward – Forward contracts are customized contracts between two parties that involve the buying or selling of an underlying asset at a future date and a predetermined price. The terms of the contract, including the quantity, price, and delivery date, are negotiated and agreed upon by the two parties. Forward contracts are typically used by businesses to manage their exposure to price fluctuations in commodities or currencies.

Advantages of Derivatives Trading

Risk management – Derivative trading offers several advantages, one of which is risk management. By investing in derivatives, investors can effectively manage their risk exposure by hedging their position in the cash market. This means that investors can use derivative contracts to offset any losses they may incur in the cash market by taking a position opposite to their existing position.
Hedging – Hedging is another advantage of derivative trading, which can be used to reduce the risk of price fluctuations in the underlying asset. For example, if an investor owns a stock and is concerned about a possible price drop, they can buy a put option in the derivative market to limit their potential losses.
Speculation – Speculation is another advantage of derivative trading, which allows investors to profit from price movements in the underlying asset without actually owning the asset itself. This means that investors can take a position on the future price movement of an asset, without actually owning it. This can be particularly beneficial for investors who do not have the financial means to purchase a large amount of the underlying asset but still want to profit from price movements.
Arbitrageurs – Arbitrageurs are traders who exploit differences in prices of the same underlying securities between two markets, thereby earning profits through market inefficiencies that others have not identified. They purchase securities in one market and sell them in another at a higher price to gain better profits.
Margin – On the other hand, margin traders use a portion of their investment amount to buy and sell financial contracts while taking credit from stockbrokers. They make profits based on the price movements of underlying assets within a single day. Margin traders identify profitable financial contracts and borrow margin credit from brokers to make purchases, returning it with interest once they sell.

The disadvantage of Derivatives Trading

Hard to value – Derivatives can be difficult to value because their value is based on the price of another asset. This can make it difficult to perfectly match the value of a derivative with the underlying asset.
Subject to counterparty default (if OTC) – Over-the-counter (OTC) derivatives are not traded on exchanges, and as a result, there is a risk of counterparty default. This means that if the other party to the trade fails to meet their obligations, the trader is at risk of losing money.
Complex to understand – Derivatives are complex financial instruments and can be difficult to understand, especially for beginners. Understanding the mechanics of derivatives trading requires a significant amount of time and effort.
Sensitive to supply and demand factors – Derivatives are vulnerable to supply and demand factors, which can cause the price and liquidity of the derivative to rise and fall, regardless of the price of the underlying asset. This can create unpredictable market conditions and increase the risk for traders.

How to get Started in derivatives trading.

Choose a quality broker and create an online trading account that supports derivatives trading. You will need a Demat account to trade in F&O contracts, so make sure your broker offers this service.
Once you have opened a Demat account, ask your stockbroker to open an F&O trading account for you.
The broker will ask you to maintain a margin amount in your account, which is required to execute or leave the contract. If your account falls below the minimum margin requirement, you will receive a margin call to rebalance the account.
Identify the financial contract you wish to trade. Remember that contracts usually have an expiry date of three months, and they expire on the last Thursday of the month. The contract must be settled by the predetermined expiry date, or it will be automatically settled on the expiration day.
Add sufficient funds to your account to buy or sell derivatives in the market. The sum is proportional to the margin needed for the agreement. Contact your broker to know about the minimum investment needed to start trading in derivatives.
Finally, start trading in derivatives by placing buy or sell orders through your trading account. Make sure to keep track of the contract’s expiry date and settle the contract before that date to avoid auto-settlement.

Leverage in derivatives trading

Leverage is a key aspect of derivatives trading, which allows traders to take larger positions in the market compared to the capital they have. It means that traders can magnify their potential profits, as well as their potential losses. This is because the value of the derivative contract is based on the underlying asset, but traders only have to deposit a fraction of the total value of the contract.

For example, if a trader wanted to take a position on a stock, they may only need to deposit a fraction of the cost of the actual share price of the stock but still get full exposure to the stock market price movements through the derivative contract. This means that traders can potentially make higher profits than they would with traditional investment, but they also face higher risks.

The impact of leverage is amplified in more volatile markets, as the price of the underlying asset moves more dramatically, which can increase the value and cost of both puts and calls. Therefore, traders often use volatility indices, such as the VIX, to monitor how volatile a particular financial market is.

Factors that impact derivatives prices

Underlying asset price: The underlying asset’s price is the primary determinant of the price of the derivative. A rise or fall in the underlying asset’s price will have a corresponding impact on the price of the derivative.
Time to expiration: The longer the time to expiration, the higher the value of the derivative. This is because a longer time to expiration allows for more opportunities for the price of the underlying asset to move in a favorable direction.
Interest rates: Changes in interest rates can impact the pricing of derivatives, especially for those derivatives that are linked to interest rate benchmarks, such as bonds.
Market volatility: Higher market volatility can result in higher prices for options and other derivatives, as it increases the likelihood that the underlying asset will move in a favorable direction.
Supply and demand: Like any other financial instrument, the prices of derivatives are subject to supply and demand factors. An increase in demand for a particular derivative will push up its price, while an oversupply can cause its price to decline.
Counterparty risk: In the case of over-the-counter (OTC) derivatives, the creditworthiness of the counterparty can impact the pricing of the derivative. A higher perceived risk of default by the counterparty can result in a higher price for the derivative to compensate for the added risk.

The Conclusion

The derivatives market has revolutionized trading by allowing traders to speculate on the future price movements of an underlying asset without actually owning it. The derivatives market allows for trading in various assets, including stocks, currencies, and commodities, which can be settled in cash without delivering the actual asset. Traders can utilize leverage to take a much larger position compared to the amount of capital they need to deploy. For businesses, derivatives act as a form of insurance through the hedging process, allowing them to avoid negative price movements and mitigate losses. Derivatives have become popular in the financial market, providing a wide range of opportunities for traders to maximize profits while minimizing risks.