Derivatives or financial derivatives, as the name suggests, are financial contracts that “derive” their value from an underlying asset. Simply put, derivatives help you make profits by taking a call on the future value of its underlying asset. There are many types of financial derivatives of many assets such as commodities, currency, indices and stocks. For the sake of simplicity however, we will delve into equity financial derivatives for better understanding.
How does an equity derivative work?
Suppose you buy a derivatives contract on stock A that is trading at Rs 2,000 in the spot market. The expiry date of the contract is a month later. At this time the stock trades at Rs 2,500 in the spot market, but you can still purchase it at Rs 2,000, thereby making a profit of Rs 500 per share. The same holds true if the stock price were to fall by Rs 500. In that case you would incur a loss of Rs 500 per share.
What are derivatives used for?
To know the uses of financial derivatives let’s look into the below terms:
Derivatives offer you the opportunity to protect yourself against price fluctuations. You can use a derivative strategy to protect yourself against a price rise or a price fall. This is called hedging.
Every investor in the market has a different risk appetite or tolerance to bear losses. Derivatives can be used effectively to transfer risks from risk-averse investors who want to protect themselves against price fluctuations to risk-tolerant investors such as speculators who take contrarian trade positions to enhance profits.
Different types of derivatives contracts
Futures and forwards:
As explained earlier, future contracts are agreements coined to buy or sell a specified number of shares at a pre-stipulated time in the future. Forwards can be called a variant of futures but ones that can be customised to a certain extent. Unlike futures, these are non-standardised in nature and cannot be traded on the exchange.
Options are similar agreements like futures, but one in which you can exercise a choice or an option to meet the obligation. For example, if you have an option contract to buy 50 shares on the expiry date, you can choose whether or not you wish to do so. Options too can be traded on the stock exchange.
What do you need to invest in derivatives?
To understand how to trade derivatives here are the following factors you need to consider:
A demat account- Just like trading in shares, a demat account is a pre-requisite for dealing in derivatives.
Trading account- A trading account is linked to your demat account and serves as your unique identity in the market.
Initial margin- When you decide to deal in derivatives, you need to deposit an initial margin, that is decided by the stock exchange. It is a risk containment measure on behalf of the exchange, and depends upon the total value of your outstanding position as well as the average volatility of the stock and interest cost over a stipulated time period. This margin is adjusted daily depending upon the market value of the open positions you hold.
Exposure margin- This margin is also levied by the exchange and is used to control excessive speculation and volatility.
Mark to market margin- Apart from the two margins mentioned above, you also need to maintain a Mark to Market (MTM) margin. This margin covers the difference between the cost and the closing price of the contract on a day to day basis.
Derivatives trading must do’s
Research- This is the most important aspect of derivatives trading. Derivatives trading is far more complex than stock trading, so do not make a trade unless you are completely sure of the position you are taking, the purpose of the same and the possible consequences.
Maintaining the margin amount- Margin maintenance plays a big role in derivatives trading. It is always prudent to maintain some extra amount in your account as the margin amount changes with the rise and fall in the underlying stocks.
Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.