Have you ever heard about the “Derivative Market”?

If not, then don’t worry because from this article it is completely on “Derivative”.

This article is on “What is Derivative in Stock Market?” and from this blog, you will get the complete detailed information about this.

Many investors use different financial instruments like derivatives, futures & options to hedge the risk.

These risks can be helpful to overcome the financial liabilities, commodities price fluctuations, or many other factors.

The companies that are financially strong or the dealers that accept the risks usually use these various strategies to hedge the risks and to make a profit out of it.

Let’s begin with the definition of Derivative.

What are Derivatives?

In the financial industry, the term “Derivative” is used as a Contract where the price is determined on the basis of the underlying assets.

Whereas, the underlying assets can be a stock, currency, commodity, or security that offers interest.

The feature that is common in all the derivatives is that all the underlying assets that possess the risk of change in value.

Derivatives are also used for trading in specific sectors like foreign exchange, equity, treasury bills, electricity, weather, temperature, etc.

For instance, Derivatives for the exchange are known as “Exchange Traded Derivatives”

According to the Securities Contract (Regulation) Act, 1956 the term “derivative” includes:

  • A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security.
  • A contract which derives its value from the prices, or index of prices, of underlying Securities. Link: https://www.sebi.gov.in/acts/contractact.pdf

Let’s now focus our mind to know the types of derivatives contract available:

What are the types of Derivatives Contracts?

Over the years, the types of derivatives contracts have evolved. The four basic types of Scottish Contracts are Futures, Options, Forwards, and Swaps.

Different types of derivatives are as follows-

  • Futures

A futures contract is a special type of forward contract where an agreement is made between two parties to buy or sell an asset at a certain time in future at a particular price.

The contract expires on a pre-specified date or on an expiry date and on expiry, futures can be settled by delivery of the underlying asset or cash.

  • Options

Options are contracts between an option writer and a buyer that gives the buyer the right to buy/sell the underlying such as assets, other derivatives etc. at a stated price on a given date.

Here, the buyer pays the option premium to the option writer i.e. the seller of the option. The option writer has to oblige if the buyer decides to exercise the right given through the options contract.

  • Forwards

It is a customized contract between two parties wherein the settlement happens on a specific date in the future at a price agreed upon on the contract date.

  • Swaps

Swaps are private contracts between two parties wherein an exchange of cash flows of the financial instruments owned by the parties takes place. The two commonly used swaps are

a) Interest Rate Swaps

This involves swapping cash flows carrying interest in the same currency.

b) Currency Swaps

This type of allows the swap of cash flows with principal and interest in different currencies.

How it is different from Equity?

The financial instruments that derive their value from underlying assets such as bonds, commodities, currencies etc. are Derivatives.

Whereas, the financial instruments that depend on demand and supply and company related, economic, and political or other events.

The equities are instruments for investment, while derivatives are used for speculation or hedging purposes.

Who and why they use Derivatives Instruments?

Derivatives are used to hedge risks and for speculative trades; and active markets need the equal participation of both such investors.

By rule of thumb, if you are a cautious investor with limited funds, learn to hedge your bets while if you are ready to take some risk and have ample funds to play the markets, not to mention also possess acumen and understanding of the Indian market trends, play the markets to your advantage.

There are three types of participants in a derivatives market: Speculators, Hedgers, and Arbitrageurs. Speculators are the high-risk takers.

They contemplate and bet on the future movement of prices based on their skill and knowledge levels with a higher-than-average risk in return for higher-than-average profit potential.

They take a risk to earn profit by buying low and selling high, or by first selling high and later buying low.

Private or Institutional Investors buy derivative contracts with a purpose.

Some of the leading players in the derivatives market are hedgers, speculators and arbitrageurs.

These can also be traders investing in futures and options on currency pairs.

1. Hedgers

They are the investors who hedge a risk. And, hedging means reducing risk with a position that will help tackle risky factors or influences arising out of current market conditions.

A hedger will try to achieve a position which is opposite to the risk he takes.

This investor will try to reduce or eliminate price risk conditions in conditions of price volatility in the market.

2. Speculators

Speculators invest in the derivatives markets by constantly studying the price movements and taking a position that gives them maximum gains.

Their intention is primarily to make maximum profits.

Compared to Hedgers, they tend to take a higher risk which can lead to maximum returns or huge loss in the markets.

Speculators have to predict future trends in the market as accurately as possible to place themselves in the right position in the market.

Speculators are the ones who wish to make greater profit with short-term investments.

To do so, they provide future forecasts on the basis of fundamental as well as technical analysis.

The speculators keep track of the fast-moving trends from fluctuating interest rates to public statements by key people and predict the direction in which the market will go.

The portfolio of speculators is huge and diversified and involves high net worth investors.

3. Arbitrageurs

Arbitrageurs operate in a swift manner with almost instant decisions being made to earn positive gains without taking any risk.

They increase the liquidity in the market by grabbing the time-bound arbitrage opportunities in the market and trading the derivatives instruments immediately.

With arbitrageurs, the investors don’t lose money, earn positive gains and trade with no risk.

Arbitrageurs take advantage of the price differences that exist for a share in different markets for a limited time

As the derivative markets deal in speculation, there is a large amount of risk involved.

The Exchanges, however, have a stringent framework for risk control and minimizing loss.

But a word of caution to retail investors, invest in derivatives only after taking care of your financial needs and as an avenue of diversifying your portfolio.

Derivatives are merely profits that you should earn and not returns that you should bank on.

Conclusion

From this article on “What is Derivative in Stock Market?” we had delivered all the relevant details about the topic with complete knowledge for particular sub-head.

This is the basic term used in the stock market with lots of practices that need to do the practical work in the significant market to hedge the risk and to make the profit from it.

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Author

Prashant Raut is a successful professional stock market trader. He is an expert in understanding and analyzing technical charts. With his 8 years of experience and expertise, he delivers webinars on stock market concepts. He also bags the ‘Golden Book of World Record’ for having the highest number of people attending his webinar on share trading.