What is a derivative?

What is a derivative?

Derivative meaning

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

  1. Forwards 

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.

  1. Futures

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

  1. Options

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. 

  1. Swaps

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. 

  1. Retail Investors

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.

  1. Institutional 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

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. 

  • Leverage

Derivatives are leveraged financial instruments. One doesn't need to pay the full contract value to trade in them.

  • Arbitrage

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

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

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

  • Over-leverage

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.

  • Volatility

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. 

  • Time-bound

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.

  • Complex payoffs

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.