Introduction to Derivatives
Introduction
In the stock market, not everyone buys or sells shares directly. Many traders, investors, and businesses use advanced financial instruments to manage risk or benefit from price movements without owning the actual asset.
These financial instruments are known as Derivatives.
Derivatives play a crucial role in modern financial markets, but they can also be risky if not understood properly. In this article, we will understand what derivatives are, their types, how they work, advantages, risks, and who should trade them.
What Are Derivatives?
A derivative is a financial contract whose value is derived from an underlying asset.
Underlying assets can be:
- Stocks (Reliance, TCS)
- Indices (Nifty 50, Bank Nifty)
- Commodities (Gold, Silver, Crude Oil)
- Currencies (USD/INR)
- Interest rates or bonds
The price of a derivative changes based on the price movement of its underlying asset.
Why Are Derivatives Used?
- To hedge risk and protect capital
- To speculate on price movements
- To manage uncertainty
- To gain leverage with lower capital
What Are the 4 Main Types of Derivatives?
1. Futures Contracts
A futures contract is an agreement to buy or sell an asset at a fixed price on a future date.
- Traded on NSE & BSE
- Standardized contracts
- Margin required
- Daily mark-to-market settlement
Example:
If you believe Nifty 50 will rise, you can buy Nifty Futures. If the index rises, you profit; if it falls, you incur losses.
2. Forward Contracts
Forward contracts are private agreements between two parties. They are traded over-the-counter (OTC).
- Customizable terms
- No exchange involvement
- Higher counterparty risk
Example:
An exporter agrees to sell USD at ₹83 after 3 months to avoid currency risk.
3. Options Contracts
Options give the buyer the right, but not the obligation, to buy or sell an asset.
- Call Option: Right to buy
- Put Option: Right to sell
- Buyer pays premium
- Loss limited to premium
Options are popular because they allow limited risk with high profit potential.
4. Swaps
Swaps are derivative contracts where two parties exchange financial obligations.
- Interest rate swaps
- Currency swaps
- Mainly used by institutions
How Do Derivatives Work?
Exchange-Traded Derivatives
- Standardized contracts
- Transparent pricing
- Low counterparty risk
- Regulated by SEBI
OTC Derivatives
- Private contracts
- Flexible terms
- Higher risk
Advantages of Derivatives
- Risk hedging
- High leverage
- Low capital requirement
- Profit in rising or falling markets
Risks of Derivatives
- High volatility
- Leverage can magnify losses
- Emotional pressure
- Not suitable for beginners
Derivatives vs Cash Market
| Factor | Derivatives | Cash Market |
|---|---|---|
| Leverage | High | Low |
| Risk | High | Moderate |
| Capital | Lower | Higher |
| Holding Period | Short-term | Long-term |
Who Should Trade in Derivatives?
- Experienced traders
- Investors with strong risk management
- Hedgers such as businesses and institutions
Beginners should first learn cash market basics and practice paper trading before entering derivatives.
Conclusion
Derivatives are powerful financial instruments used for hedging and speculation. They offer high profit potential but involve significant risk.
Success in derivatives trading requires proper education, discipline, risk management, and emotional control.
“Protect capital first. Profits will follow.”