A derivative is a contract or product that derives its value from an underlying asset. Derivatives can include a wide range of such assets including indices, currencies, exchange rates, commodities, stocks or the rate of interest. The buyer and seller of such contracts have opposite estimations of the future trading price. Both the parties bet on the future value of the underlying assets to make a profit.
Derivative trading is similar to a regular buy and sell process. But instead of paying the whole amount up front, a trader pays only an initial margin to a stockbroker.
Different Types of Derivatives
Depending upon the conditions of a contract, derivatives can be of the following types –
- Futures – A futures contract is a legal agreement between two parties to buy or sell the underlying asset at a predetermined future date and price. The contract is executed directly through a regulated and organised exchange.
- Forwards – Forward contracts are similar to futures except the deal is not made through an organised or regulated exchange. Since these are Over-The-Counter (OTC) contracts, they carry more counterparty risk for both parties involved.
- Options – An options contract gives a trader the right but not an obligation to buy or sell an underlying asset at a predetermined future date and price.
- Swaps – A swap is a contractual agreement between two parties to exchange cash flows at a future date based on a pre-planned formula. Similar to forwards, they are OTC contracts and consequently not traded on exchanges.
Although forwards and futures may seem similar to each other, there are some key differences to them:
|Point of Difference
|Nature of contract
||These are standardised contracts.
||These types of contracts are tailor-made to suit the requirements of both the parties; These are not standardised.
||These are settled on a daily basis.
||These are settled on the date of maturity.
||The risk associated with a futures contract is low.
||The level of risk associated with forwards is high.
||An initial margin is required as collateral for the credit risk.
||No collateral is required for forwards.
|Method of transaction
||These are traded on regulated and organised stock exchanges such as BSE and NSE.
||These are Over-The-Counter (OTC) contracts, negotiated directly between a buyer and a seller. They’re not traded on a regulated and organised exchange.
Participants in a Derivatives Market
There are four participants involved in derivative trading. They are as follows –
- Hedgers – These participants invest in the derivatives market to eliminate the risks associated with future price changes.
- Traders and speculators – They predict future changes in the price of an underlying asset. Based on these predictions, they take a certain position (long or short) in a derivative contract.
- Arbitrageurs – Arbitrage is a practice often adopted by traders to exploit the price differences in two or more markets. For example, a trader purchases stock in one market and simultaneously sells it off at a higher price in another. It is a common practice in financial markets.
- Margin traders – In derivative trading, a margin is an initial amount an investor has to pay to the stockbroker. It is only a percentage of the total value of the investor’s position. Margin traders use this distinct payment feature to buy more stocks than they can afford.
Advantages of Derivative Trading
- Low transaction costs – Derivative contracts play a part in reducing market transaction costs since they work as risk management tools. Thus, the cost of transaction in derivative stock trading is lower as compared to other securities like debentures and shares.
- Used in risk management – The value of a derivative contract has a direct relation with the price of its underlying asset. Hence, derivatives are used to hedge the risks associated with changing price levels of the underlying asset. For example, Mr A buys a derivative contract, the value of which moves in the opposite direction to the price of the asset he possesses. He’ll be able to use the profits in the derivatives to offset losses in the underlying asset.
- Market efficiency – Derivative trading involves the practice of arbitrage which plays a vital role in ensuring that the market reaches equilibrium and the prices of the underlying assets are correct.
- Determines the price of an underlying asset – Derivative contracts are often used to ascertain the price of an underlying asset.
- Risk is transferable – Derivatives allow investors, businesses and others to transfer the risk to other parties.
Disadvantages of Derivative Trading
After knowing what is derivative trading, it’s imperative to be familiarised with its disadvantages as well.
- Involves high risk – Derivative contracts are highly volatile as the value of underlying assets like shares keeps fluctuating rapidly. Thus, traders are exposed to the risk of incurring huge losses.
- Counterparty risk – Derivative contracts like futures that are traded on the exchanges like BSE and NSE are organised and regulated. But, OTC derivative contracts like forwards, are not standardised. Hence, there’s always a risk of counterparty default.
- Speculative in nature – Derivative contracts are commonly used as tools for speculation. Due to the high risk associated with them and their unpredictable fluctuations in value, baseless speculations often lead to huge losses.
Derivative trading requires in-depth knowledge about the products and a great deal of expertise. All investors need to conduct thorough research regarding this process and formulate effective strategies to minimise losses and optimise profits.