What is Derivative Trading?

What is Derivative Trading?

What is a derivative?

A derivative is something which is based on another source. 

Let's take paneer for instance. The price of paneer is dependent on the price of milk. It can be said that paneer is a derivative of milk (source). 

The source, which is milk in this case, is referred to as the underlying. Any movement in the price of milk will be reflected in the price of the corresponding derivative which in this case is paneer.

Derivative trading 

Derivatives trading refers to the buying and selling of derivative contracts. Derivative contracts are essentially time-bound financial instruments with a fixed expiry date.

Broad classification of derivatives on the basis of where they are traded

OTCs

  1. OTC full form:Over the counter derivatives.
  2. OTC meaning: Over the counter derivatives are derivative contracts between the private parties that do not follow the procedure of being distributed and traded on exchange or being cleared through a clearing house.
  3. The terms and conditions are customised to meet the needs of the buyer and the seller.
  4. There exists a counterparty default risk as there is no regulator involved.

ETDs 

  1. ETD full form: Exchange traded derivatives.
  2. ETD meaning: Exchange traded derivatives are derivative contracts that are publicly traded on exchanges and that are cleared through a clearing house.
  3. These are standardised in order to facilitate trade.
  4. Exchanges act as a regulator to eradicate the default risk.
  5. Exchange traded contracts are electronically traded and important details related to transactions like open interest, volume and price are made available in public domain.

Exchange Traded Derivatives in India

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. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are the most popular stock exchanges in India.

Types of Derivative Contracts traded on Exchanges in India

Futures

  • A futures contract is a standardised derivative 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.
  • 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.

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 predetermined date.
  • 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.

Types of Exchange-traded derivatives based on Underlying 

Equity derivatives

  • Equity derivatives meaning: Equity derivatives refer to the derivative contracts based on shares that are available for trade via both futures and options.They are also known as stock derivatives. 
  • Eg. Reliance Industries Futures and Reliance Industries options are based on the Reliance Industries share.

Index derivatives

  • An index in the financial market measures the price performance of a basket of securities using a standardised metric and methodology.
  • They are frequently used as benchmarks to evaluate an investment's performance.
  • Index derivatives meaning: Index derivatives refer to the derivative contracts based on an Index that are available for trade via both futures and options.
  • Eg. Nifty50 futures and Nifty50 options are based on the Nifty50 Index.

Currency derivatives

  • Currency derivatives meaning: Currency derivatives refer to the derivative contracts based on the exchange rate of a pair of currencies that are available for trade via both futures and options.
  • Eg. Indian Rupee vs United States Dollar (INR-USD).

Commodities

  • Commodities refer to perishables like fresh fruits, non-perishables like nuts and seeds, (bullions) precious metals like gold, silver etc.
  • Commodity derivatives meaning: Commodity derivatives refer to the derivative contracts based on a commodity, that is available for trade via both futures and options.
  • Example: Aluminium, Cotton, etc. 

Bonds

  • Bond derivatives meaning: Bond derivatives refer to the derivative contracts based on a bond.
  • Eg. On NSE, there are two instruments available on which interest rate futures are traded:
  • NBF II - Futures on Govt. of India securities for 6,10 and 13 years
  • 91DTB - Futures on Govt. of India treasury bill for 91 days
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