A derivative is a contract or product that derives its value from an underlying asset. Derivatives can include a wide range of such assets including indices, currencies, exchange rates, commodities, stocks, or the rate of interest. The buyer and seller of such contracts have opposite estimations of the future trading price. Both the parties bet on the future value of the underlying assets to make a profit.
Derivative trading is similar to a regular buy and sells process. But instead of paying the whole amount up front, a trader pays only an initial margin to a stockbroker.
Different Types of Derivatives
Depending upon the conditions of a contract, derivatives can be of the following types –
- Futures –A futures contract is a legal agreement between two parties to buy or sell the underlying asset at a predetermined future date and price. The contract is executed directly through a regulated and organised exchange.
- Forwards –Forward contracts are similar to futures except the deal is not made through an organised or regulated exchange. Since these are Over-The-Counter (OTC) contracts, they carry more counterparty risk for both parties involved.
- Options –An options contract gives a trader the right but not an obligation to buy or sell an underlying asset at a predetermined future date and price.
- Swaps –A swap is a contractual agreement between two parties to exchange cash flows at a future date based on a pre-planned formula. Similar to forwards, they are OTC contracts and consequently not traded on exchanges.
Although forwards and futures may seem similar to each other, there are some key differences to them:
| Point of Difference | Futures | Forwards |
| Nature of contract | These are standardised contracts. | These types of contracts are tailor-made to suit the requirements of both the parties; These are not standardised. |
| Settlement date | These are settled on a daily basis. | These are settled on the date of maturity. |
| Risk involved | The risk associated with a futures contract is low. | The level of risk associated with forwards is high. |
| Collateral requirement | An initial margin is required as collateral for the credit risk. | No collateral is required for forwards. |
| Method of transaction | These are traded on regulated and organised stock exchanges such as BSE and NSE. | These are Over-The-Counter (OTC) contracts, negotiated directly between a buyer and a seller. They’re not traded on a regulated and organised exchange. |
Participants in a Derivatives Market
There are four participants involved inderivative trading. They are as follows –
- Hedgers –These participants invest in the derivatives market to eliminate the risks associated with future price changes.
- Traders and speculators –They predict future changes in the price of an underlying asset. Based on these predictions, they take a certain position (long or short) in a derivative contract.
- Arbitrageurs – Arbitrage is a practice often adopted by traders to exploit the price differences in two or more markets. For example, a trader purchases stock in one market and simultaneously sells it off at a higher price in another. It is a common practice in financial markets.
- Margin traders –In derivative trading, a margin is an initial amount an investor has to pay to the stockbroker. It is only a percentage of the total value of the investor’s position. Margin traders use this distinct payment feature to buy more stocks than they can afford.
Advantages of Derivative Trading
- Low transaction costs –Derivative contracts play a part in reducing market transaction costs since they work as risk management tools. Thus, the cost of transactionin derivative stock tradingis lower as compared to other securities like debentures and shares.
- Used in risk management –The value of a derivative contract has a direct relation with the price of its underlying asset. Hence, derivatives are used to hedge the risks associated with changing price levels of the underlying asset. For example, Mr. A buys a derivative contract, the value of which moves in the opposite direction to the price of the asset he possesses. He’ll be able to use the profits in the derivatives to offset losses in the underlying asset.
- Market efficiency – Derivative tradinginvolves the practice of arbitrage which plays a vital role in ensuring that the market reaches equilibrium and the prices of the underlying assets are correct.
- Determines the price of an underlying asset –Derivative contracts are often used to ascertain the price of an underlying asset.
- Risk is transferable –Derivatives allow investors, businesses and others to transfer the risk to other parties.
Disadvantages of Derivatives Trading
After knowing what is derivative trading, it’s imperative to be familiarised with its disadvantages as well.
- Involves high risk –Derivative contracts are highly volatile as the value of underlying assets like shares keeps fluctuating rapidly. Thus, traders are exposed to the risk of incurring huge losses.
- Counterparty risk –Derivative contracts like futures that are traded on the exchanges like BSE and NSE are organised and regulated. But, OTC derivative contracts like forwards, are not standardised. Hence, there’s always a risk of counterparty default.
- Speculative in nature –Derivative contracts are commonly used as tools for speculation. Due to the high risk associated with them and their unpredictable fluctuations in value, baseless speculations often lead to huge losses.
Derivative trading requires in-depth knowledge about the products and a great deal of expertise. All investors need to conduct thorough research regarding this process and formulate effective strategies to minimise losses and optimise profits.
FAQs
Advantages include hedging against risk, market efficiency, determining asset prices, and leverage. However, derivatives have drawbacks, such as counterparty default, difficult valuation, complexity, and vulnerability to supply and demand.
What are the 4 types of derivatives? ›
In finance, there are four basic types of derivatives: forward contracts, futures, swaps, and options.
What are the advantages and disadvantages of derivatives trading? ›
Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares. The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks.
What is derivative trading? ›
A derivative is a formal financial contract allowing the investor to buy or sell an asset for future periods. A fixed and predetermined expiry date is set for a derivative contract. Trading derivatives on the stock market is better than buying the underlying asset since the gains can be significantly exaggerated.
What are the two main ways that derivatives trade? ›
The first is over-the-counter (OTC) derivatives, that see the terms of the contract privately negotiated between the parties involved (a non-standardised contract) in an unregulated market. The second way to trade derivatives is through a regulated exchange that offers standardised contracts.
What are the top 5 derivatives? ›
Five of the more popular derivatives are options, single stock futures, warrants, a contract for difference, and index return swaps.
What are the two most common derivatives? ›
Common underlying assets include investment securities, commodities, currencies, interest rates and other market indices. There are two broad categories of derivatives: option-based contracts and forward-based contracts.
Is derivatives trading good or bad? ›
Risks of Derivatives
So is the leverage risk of adverse market moves where large margin amounts may be demanded. There's the risk of trading on unregulated exchanges. For complex derivatives derived from more than one asset, there's also the risk that a proper value cannot be determined for the derivative.
Why do investors use derivatives? ›
The parties involved in a derivative transaction may instead be using the derivative to: Hedge a financial position. If an investor is concerned about where the value of a particular asset will go, they can use a derivative to protect themselves from potential losses. Speculate on an asset's price.
Who benefits from derivatives? ›
Advantage: Derivatives act as powerful risk management tools, allowing investors to hedge against price fluctuations and uncertainties. Example: A farmer may use futures contracts to protect against the volatility of crop prices, ensuring a stable income.
Another risk associated with derivatives is credit risk—the risk that the counterparty to the derivative contract will default on their obligations. If a counterparty defaults on a derivative contract, the investor may not receive the full value of the contract, leading to losses.
How do derivative traders make money? ›
By making a calculated bet on the future value of the underlying asset, such financial instruments can help derivatives traders earn a profit. Hence, their value is thereby derived from that asset, which is why they are referred to as 'Derivatives'. Underlying assets change their value every now and then.
How to master derivatives trading? ›
Understand the Basics- Start your derivatives trading journey by making a strong foundation. Learn about the basic concepts of the stock market like stocks, bonds, options etc. Derivatives derive their value from an underlying asset so it is important to understand the fundamentals strongly.
Should I invest in derivatives or equities? ›
Choose Stocks If: You prefer steady ownership, long-term growth potential, and are willing to ride out market fluctuations. Choose Derivatives If: You have experience in financial markets, are comfortable with higher risk, and seek diverse trading strategies or risk management tools.
What are the four common types of derivatives? ›
The 4 Basic Types of Derivatives
- Type 1: Forward Contracts. Forward contracts are the simplest form of derivatives that are available today. ...
- Type 2: Futures Contracts. A futures contract is very similar to a forwards contract. ...
- Type 3: Option Contracts. ...
- Type 4: Swaps. ...
- Authorship/Referencing - About the Author(s)
Financial derivatives can offer many benefits to investors, such as hedging against risk and providing opportunities for greater profits. However, they also have their fair share of disadvantages, including potential losses and complex market dynamics.
What are the 4 derivative rules? ›
Derivative Rules
| Common Functions | Function | Derivative |
|---|
| Product Rule | fg | f g' + f' g |
| Quotient Rule | f/g | f' g − g' fg2 |
| Reciprocal Rule | 1/f | −f'/f2 |
| Chain Rule (as "Composition of Functions") | f º g | (f' º g) × g' |
24 more rowsSince 4 is constant with respect to x , the derivative of 4 with respect to x is 0 .
What are the 4th 5th and 6th derivatives called? ›
In physics, the terms snap, crackle and pop are sometimes used to describe the fourth, fifth and sixth time derivatives of position respectively. The first derivative of position with respect to time is velocity, the second is acceleration, and the third is jerk.
Who are the 4 participants in derivatives? ›
Participants include hedgers, speculators, margin traders, and arbitrageurs. Types of derivative contracts include options, forwards, futures, and swaps. Trading in the derivatives market involves understanding strategies, margin requirements, and active trading accounts.
