Introduced in 2000, derivatives trading has become a very popular trading option for investors. In fact, it has been learned that the turnover of the derivatives segment on the National Stock Exchange is much more than that of the cash segment.
What are Derivatives?
Derivatives are nothing but financial instruments, which obtain or derive their value from underlying assets such as stocks, indices, commodities, or currencies. You can make profits on derivatives by speculating the future price movement of the asset.
These underlying assets such as commodities, currencies, or stocks are dynamic in nature and are subject to frequent rise and fall. Hence, derivatives enable you to make profits if you bet on their future prices correctly or lets you limit your losses in case the prices fall drastically in the spot market.
What is the Use of Derivatives?
Futures and Options are the most popular derivatives in India. These instruments are traded extensively on the stock exchanges. Some of the uses of the derivatives are:
• Earn profits without disturbing your shares
Suppose you want to hold on to your shares for the long-term, do not want to sell them, you can still make gains out of their short-term price fluctuations. Derivatives can be of great help to you in this case. You can undertake transactions without actually selling your shares.
• Taking advantage through arbitrage
Gaining benefits due to the difference in market prices from the same asset is known as arbitrage. Derivatives allow you to buy low in a market and sell high in another market. The difference in the market prices is your profit.
• Hedging against price fluctuations
The derivatives market offers products that enable you to hedge your position against the possible decline in the price of the shares owned by you. Not only this, derivatives also have products that provide you with protection against the possible rise in prices that you intend to buy. This particular phenomenon is called hedging. Briefly, derivatives protect you from price fluctuations either way.
• Transfer of risk
One of the most widely accepted applications of derivatives is to balance the risk by transferring it prudently. Derivative instruments strike a balance by transferring the prevailing risk element from risk-averse investors to the one with greater risk-taking ability. Investors with a low appetite for risk, use derivatives to ensure safety, while investors with high risk-taking ability, such as speculators, conduct risky trades to earn more profits. There are various products and strategies, which can be used to balance risk and earn maximum profits from Derivative instruments.
Who are the Different Participants in the Derivatives Markets?
The participants in the derivatives market are classified into four categories based on their trading motives. These include hedgers, speculators, margin traders, and arbitragers. Let us try to understand each of these participants in details:
Participants who mainly aim at reducing their losses due to fluctuations in the stock market are known as hedgers. They use derivatives for this purpose mainly. The trick is to take a diametrically opposite position in the asset whose price they wish to hedge. They are so wary of the fluctuations in the prices of the assets and losses that can happen because of this that they agree to pay a pre-decided cost to relieve themselves of this stress.
During the process of hedging, you are passing all the underlying risks to someone who is willing to take it. However, have you ever thought, why will someone be willing to take this risk? This is because some people love to take risks in the market no matter what. They completely believe in the saying that risk and returns go hand in hand. They put their money at stake with firm philosophy that the more the risk, the better the returns. They are always on the verge of looking for opportunities to take a risk. There are two kinds of speculators: The day trader and the position traders. A day trader intends to take advantage of the intraday fluctuation in the prices. They square off their position on the same day itself. On the other hand, position traders hold onto the stock for weeks or months in the hope of better profits. They base their stances on research (fundamental and technical), news, price prediction techniques, and tips.
• Margin traders
There is a unique payment mechanism in the derivatives market. The traders can take a position without making the full payment. They function on credit and need to deposit only a small portion of their money, which is known as margin money. However, there is a limit to this. The speculator is allowed to take three to five times the position exceeding the margin money. Otherwise, they need to pay the outstanding money or undertake an opposite position to annul the amount in question.
Arbitragers are traders who take advantage of price imbalances in the market. These traders are low on risk appetite and conduct simultaneous trades. They purchase securities in one market and sell the same security in the other market to earn profits out of price differential.
How are the Derivatives Contract Linked to Stock Prices?
Let us suppose that you undertake a future contract of Reliance (RIL) in the spot market at the price of INR 1,100. This is the price of the security in the stock exchange. After a month, your contract is supposed to expire. The price of RIL at that time is INR 1,300. You make a profit of INR 200 per share. Thus, the derivatives contract derived its price from the underlying asset, which was a RIL stock. If there was no change in the price, you would have received nothing. On the flipside, if the stock price had declined to INR 1,000, you would have lost INR 100.
How to Trade in the Derivatives Market
• Conduct research
You need to conduct a thorough research before taking a plunge in the derivatives segment. The strategies used in the derivatives segment are completely different from that of the stock market. In fact, you may have to opt for a totally opposite stance than what you would have adopted for the cash segment.
• Arrange for the margin money
In derivatives trade, you need to constantly maintain your margin money. Until there is trade settlement, you cannot take out the amount from your trading account. Also, remember that the margin requirements change as the price of the stock fluctuates. Hence, you must keep extra money handy.
• Conduct trade through the trading account
You must ensure that your brokerage allows you to trade in the derivatives segment. Or else, you may request your broker to activate the facility in your online trading account. Once you are allowed to trade in the derivatives segment, you can place the order online or by calling your broker. Select stocks and contracts that fit into your budget. This means that you should be able to buy the stocks based on your margin money.
• You need to wait till the settlement
In the derivatives segment, you need to wait until the expiry of the contract to settle the trade. If you have to pay the outstanding amount, you may need to conduct an opposing trade on/before the expiry to make the settlement.
What are the Pre-requisites to Invest in the Derivatives Segment?
Trading in the derivatives segment is quite similar to trading in the cash (equities) segment of the stock markets. There are three main requisites for investing in the derivatives segment:
This is an account in which all your shares and securities are stored and maintained in an electronic format. This account is unique and different for each investor.
• Trading account
You need to open a trading account. Your online trading account is the primary account through which you conduct trades. This is also linked to your demat account to ensure that after the trade completion, the shares and securities are transferred to your particular account.
• Fulfilling margin requirements
This is a requirement that is unique to the derivatives segment. While many cash traders also use margin to conduct trades, the derivatives segment uses it more.