- Zero Days to Expiration (0DTE) Options and How do They Work?
- What is an Outright Option?
- What is a basket option?
- What Are Mountain Range Options?
- What are Futures Equivalent?
- What are STIR Futures & Options: Definition, Price Quotation & Example
- Cost-of-Carry: Definition, Carry Model & Example
- What is Managed Futures Account: Definition, Advantages & Example
- What is an Outright Futures Position: Definition, Advantages, & Example
- What is a Futures Commission Merchant - Role, Obligations & Responsibilities
- Gold Futures
- What is the Fed Fund?
- What is Futures Spread
- What are shout options?
- What is a Short combination?
- What are currency derivatives?
- What are Long-dated Options?
- What are Swap Derivatives?
- What Is a Multi-Leg Options Order?
- Copper Futures
- Receiver Swaptions
- Tips for Getting Into Futures Trading
- What are market indicators?
- What is Margin Money?
- What is Short Covering?
- All About Commodity Options
- Futures and Options
- What is a Diagonal Spread and How does it work
- What is Credit Spread Strategies
- What is Box Spread trading Strategy
- What is Eurex? Understand Here!
- How are options settled?
- What are Naked Options?
- What is Option Premium
- What is Long Combo Option Trading Strategy
- What is a Cash Settlement?
- What are Oil futures
- What are Forex Options?
- What are Exchange Traded Derivatives?
- What are Equity Derivatives?
- What is Quadruple Witching
- What is Zero-Cost Collar Strategy
- What are Weekly Options?
- Synthetic Options Spread
- What are Commodity Options?
- What is Hedging with Futures?
- What is a Protective Put?
- What is call writing?
- What are Bermuda Options
- Put Writing Strategies
- What Is Call Option?
- What are Collateralized Debt Obligations?
- What is Derivative Trading?
- Options Trading Strategies: Vertical Spreads and Synthetic option spreads
- What is a fiduciary call? Understand here
- Short Put Ladder Options Strategy
- Long Call Condor Option Strategy
- Long Call Ladder Options Strategy
- Short Call Condor Options Strategy
- Short Call Ladder Options Strategy
- What are cash secured puts?
- How to Use LEAPS for Covered Call writing
- How to Calculate F&O Turnover
- Why futures prices converge upon spot prices
- What is E-mini futures
- Seagull Options
- What is Put Ratio Spread
- What is a hedging strategy?
- What is a bond option?
- What are bond futures?
- What is a derivative?
- What are commodity futures?
- Options arbitrage strategies
- What is a call ratio backspread option strategy
- Difference between warrants and calls
- What is a Short Put Butterfly option strategy
- What are over the counter (OTC) options
- How are futures prices determined
- Top 10 Mistakes when trading cheap options and how to avoid them
- How to be a successful options trader?
- What is cross currency swap
- What is expiration time in options trading?
- What is options trading?
- What are Index Futures?
- What is LTP in the Share Market?
- What is a Strike Price?
- What is Spot Price?
- What is an Underlying Asset?
- What is a Forward Contract?
- What is futures trading?
- Benefits of trading in futures
- Show all articles
What is a derivative?
A derivative is something which is based on another source.
Let's take gold jewellery for instance. The price of gold jewellery is dependent on the price of gold. So it can be said that gold jewellery is a derivative of gold (source).
The source, which is gold in this case, is referred to as the underlying. So any movement in the price of gold will be reflected in the price of the corresponding derivative which is gold jewellery.
Derivative trading meaning
Derivatives trading refers to the buying and selling of derivative contracts. Derivative contracts are essentially short-term financial instruments with a fixed expiry date.
Types of derivatives
A forward contract is a customisable derivatives contract between two parties to buy or sell an asset at a predetermined price on a future date. A forward contract is physically settled, which means it is considered to be fulfilled when the goods are exchanged.
A futures contract is a standardised derivatives contract between two parties to buy or sell an asset at a predetermined price and quantity on a specified date in the future. Futures contracts are standardised in terms of quality and quantity to facilitate trading on a futures exchange.
Exchanges act as a regulator to eradicate the default risk, which was a shortcoming of the forward contract that led to the evolution of futures. In order to trade in futures, both the buyer and the seller need to keep a margin. A future contract is either cash settled or physically settled.
Futures derivatives contracts of indices and stocks are widely traded
Options are standardised derivatives contracts that enable the buyer (holder or owner) of the instrument the right to buy or sell the underlying asset at a predetermined price and quantity on a specified date in the future. The right to buy is without any obligation. The seller of the option is, however, obligated to buy or sell, should the buyer exercise his or her right. Option contracts are standardised in terms of quality and quantity to facilitate trading on an exchange. Option contracts are either cash settled or physically settled.
Option derivatives of indices and stocks are widely traded.
Swaps refer to a customisable derivatives contract wherein two parties exchange liabilities or cash flows. Swap trading can be done on commodities, equities, interest rates, currencies etc. They are traded over-the-counter primarily between financial institutions or businesses. The terms of the swap contract are negotiated and customised to the needs of both parties as they are traded over the counter. They are risky in nature as one party can default on the payment thus leading to counterparty risk.
Derivatives in stock market
In the Indian stock market, there is an entire segment where derivatives are traded, it is known as the F&O (Futures and Options) segment. Trading volumes in derivatives contracts are significant, making them popular instruments among market participants.
Participants in derivatives market
Derivatives markets participants can broadly be classified retail and institutional.
Retail investors refer to individuals who purchase securities directly, including through brokers on the basis of instruction or invest their own money on their own. High Networth Individuals (HNI) investing on behalf of themselves are also considered retail investors.
Institutional investors refer to companies or organisations who invest on behalf of others. These can be further divided as Foreign Institutional Investors (FII) and Domestic Institutional Investors (DII). FII is an institution established or incorporated outside India which proposes to make investment in India in securities. DII is an Indian institution or organisation such as a bank, insurance company or a mutual fund house that invests in Indian securities.
Pros of derivative trading
Hedging means to protect. Derivatives can be used by risk-averse traders to protect themselves from possible price fluctuations in the future. Futures and options trading offers them price stability in such instances. For example, commodity futures enable hedging against price fluctuations which eliminate uncertainty for producers, traders and end-users.
Derivatives are leveraged financial instruments. One doesn't need to pay the full contract value to trade in them.
Arbitrage refers to buying an asset in the market where the price is lower and selling the asset in the market where the price is higher. Traders take advantage of pricing differences of the same asset in different markets to earn a profit.
Speculation refers to the buying, holding, selling or short-selling of derivatives in order to gain money from price fluctuations in the market.
Short Selling refers to selling first and then buying. This is allowed on an intraday basis in the cash segment. However, in the F&O segment traders can carry forward their position.
Cons of derivative trading
As traders don't have to pay the full contract value, they may over leverage and this is very risky as derivatives being leveraged instruments magnify not only profits, but also losses.
Derivative markets are highly volatile in nature. They are influenced by a lot of factors including events from around the world and price changes can be swift and big.
Derivatives in India can be traded for a maximum duration of 3 months, so they are time-bound in nature. It is possible that movement in the favourable direction doesn't happen before the expiry of the contract.
No ownership of the company
When traders deal in derivatives they become the contract holders of the company and not the shareholders. So they do not receive direct benefits of corporate actions such as dividends, bonus shares, voting rights, etc.
Trading in derivatives is complex, due to variation in payoff depending on time till expiration and instrument used, especially options. Therefore, trading in multi-legged option strategies should be pursued with utmost care and guidance from SEBI registered professionals.