Imagine you are planning a vacation, and you are worried that airfare prices might skyrocket by the time you book your tickets. To tackle this uncertainty, you agree with a travel agent to lock in the current price for your tickets, ensuring you won’t pay more later. This kind of agreement mirrors the essence of derivatives in finance. Derivatives are contracts whose value is linked to the performance of an underlying asset. In this blog, we will delve into the meaning of derivatives and explore their various types.
What are Derivatives?
Derivatives are financial contracts whose value derives from an underlying asset, index, or benchmark. These instruments can be traded on exchanges or over-the-counter (OTC). Traders and investors often use derivatives to manage risk or speculate on the price movements of the underlying assets.
Components of a Derivative Contract
A derivative contract typically comprises several essential components that shape its functionality:
- Underlying Asset: This asset is what determines the value of the derivative. It could be stocks, bonds, commodities, currencies, or other derivatives.
- Contract Size: This refers to the amount of the underlying asset covered by the contract. For instance, a futures contract might represent 100 shares of a stock.
- Expiration Date: The date by which the contract must be settled. For options and futures, this is when the holder must decide to either exercise their option or complete the contract.
- Strike Price: The predetermined price at which the holder can buy or sell the underlying asset. The strike price is crucial in determining the profitability of an options contract.
- Premium: In the case of options, this is the fee paid by the buyer to the seller for the rights granted by the option.
- Settlement Terms: These outline how the contract will be settled, whether by physical delivery of the asset or through cash settlement.
- Counterparty Risk: This refers to the risk that one party in the contract may not fulfil their obligations. OTC derivatives generally have higher counterparty risks than exchange-traded derivatives.
Types of Derivatives
Market Derivatives can be categorised into four primary types:
Futures Contracts
Futures contracts are agreements where the buyer agrees to purchase, and the seller agrees to sell an asset at a specified price on a predetermined future date. These standardised contracts are traded on futures exchanges, providing a high level of transparency and liquidity.
Example: Suppose you believe coffee prices will rise in the coming months. You buy a futures contract for 5,000 kilograms of coffee at ₹150 per kilogram, set to expire in three months. If, at expiration, coffee prices have climbed to ₹180 per kilogram, you can sell the contract at this new market price, making a profit of ₹30 per kilogram. However, if prices drop to ₹120 per kilogram, you must complete the trade at the agreed price, resulting in a loss of ₹30 per kilogram.
Swaps
Swap contracts involve the exchange of cash flows or financial assets between two parties over a set period. They help manage risks related to fluctuations in interest rates, currencies, or other financial variables. Unlike standardised instruments, swaps are primarily OTC agreements, offering greater flexibility.
Example: Consider a tech company in India that has taken a loan in US dollars and is concerned about currency fluctuations. Meanwhile, a European firm has a loan in euros and seeks to take on dollar debt. They agree to a currency swap, where the Indian company pays interest in euros and the European firm pays in dollars. By doing so, both companies mitigate their currency risks while fulfilling their respective funding needs.
Forward Contracts
Forward contracts are customised agreements where two parties agree to exchange an asset at a specified price on a future date. Unlike standardised futures contracts, forwards offer flexibility tailored to the needs of both parties.
Example: Imagine you are a vineyard owner expecting to harvest 10,000 bottles of wine in a year. To safeguard against potential price drops, you enter into a forward contract with a local distributor, agreeing to sell your wine at ₹800 per bottle. Regardless of the market price at harvest time, the distributor is obliged to buy your wine at this agreed price, providing you with financial stability.
Options
An options contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before the contract expires. There are two main types: call options (which provide the right to buy) and put options (which provide the right to sell).
Example: Let’s say you are keen on investing in the shares of Reliance Industries, currently trading at ₹2,000. You purchase a call option with a strike price of ₹2,200, paying a premium of ₹100 per share for the right to buy 50 shares within a month. If the share price rises to ₹2,500, you can exercise your option, buying at ₹2,200 and selling at ₹2,500, earning a profit of ₹200 per share (minus the premium). However, if the price remains below ₹2,200, you can let the option expire, limiting your loss to the premium paid.
Key Differences Between Derivatives
While derivative trading serves similar purposes, they exhibit distinct characteristics that influence their usage and risk profiles. Here is a comparison of the main types:
| Type | Traded On | Standardisation | Obligation |
| Futures | Exchanges | Standardised | Obligation to buy/sell |
| Options | Exchanges | Standardised | Right, but not an obligation |
| Swaps | OTC | Customised | Mutual obligation |
| Forwards | OTC | Customised | Obligation to buy/sell |
Importance of Derivatives
Derivatives hold great significance in the market. Here is how:
Price Discovery
The trading of derivatives reflects market participants’ expectations about future price movements. This helps investors gain insights into the anticipated pricing of underlying assets.
Leverage
Derivatives allow investors to gain exposure to larger market positions without needing substantial initial capital. This leverage can enhance potential returns, but it also increases risk.
Speculation
Traders often use derivatives to speculate on future price movements. They can profit from market fluctuations by predicting price changes, even in declining markets.
Diversification
Derivatives can provide investors access to various assets and markets, facilitating greater diversification of their investment portfolios.
How to Get Started with Derivatives Trading
Choosing the right derivatives app is essential if you are keen to dive into derivative trading. Here are some steps to kickstart your journey:
- Choose a Reputable Derivatives App: Look for apps that offer user-friendly interfaces and comprehensive educational resources on derivatives trading.
- Open a Demat Account: You will need to open Demat account to start trading in derivatives. Ensure you provide all necessary documents and complete the KYC process.
- Educate Yourself: Before diving into trading, take the time to learn about different types of derivatives, their uses, and the associated risks.
- Start Small: As a beginner, starting with smaller trades is wise until you gain confidence and an understanding of the market dynamics.
- Keep Track of the Market: Use the stock app to monitor market trends, price movements, and relevant news to make informed trading decisions.
Conclusion
Derivatives are crucial financial instruments that derive their value from underlying assets, including stocks, commodities, and currencies. Understanding derivatives and their various types, such as futures, swaps, forwards, and options, can help you make informed decisions in trading and risk management. Whether you are hedging against price fluctuations or speculating on market movements, derivatives offer valuable opportunities in the financial markets.
If you are ready to embark on your derivative trading journey, consider downloading a dedicated derivatives app today from HDFC SKY. With the right tools and knowledge, you can navigate the derivatives market and make the most of your investments.
