The derivatives market is a type of financial market for derivatives or financial instruments such as futures contracts and options, whose values are based on different underlying assets such as Commodities, Currencies, Stocks, Securities, etc.
These assets are traded in spot markets, and their prices are often referred to as spot prices, though they can simply be referred to as stock, bond, exchange rate, and commodity prices.
These global markets have attracted traders in a short time. As a result, financial specialists and the general public are aware of them.
The key participants of the derivatives market are Arbitrageurs, Hedgers, and Speculators. In addition, there are four types of derivative instruments: forward, futures, option, and swap.
Continue reading this article till the end to understand more about the Derivatives market and its types. But before we move forward, here’s a short description of the underlying asset.
What is an Underlying Asset?
The asset on which a derivative contract is based is known as the underlying asset. The derivative price may be directly (call option) or inversely (put option) associated with the underlying asset’s price.
A stock, commodity, index, currency, or even a derivative product might be used as an underlying asset.
Typically, the underlying asset trades on a spot market, where the item must be purchased in full upfront (or within a period of 1-2 days).
Different Participants in the Derivative Market:
Every individual trader will have a goal in mind when it comes to participating in the derivatives market.
Based on their trade motivations, they are categorized into the following groups:
Hedgers are stock market traders that are risk cautious. They use derivatives markets to protect their investment portfolio from market risk, market downturn, and price fluctuations.
They accomplish this by taking the opposing side of the derivatives market. They pass the risk of loss to those who are willing to accept it in this way. However, they are subject to paying a premium to the risk-taker for the available hedging.
Speculators are investors who examine the price factor and, after careful consideration, invest when the price factor favours the greatest returns.
The only rule is to make as much money as possible through derivative investments. Unlike hedgers, they are not afraid to take bigger risks, ensuring maximum gains and occasionally huge losses during market downturns.
In order to discover the best position in the market, speculators must identify future market movements as precisely as possible. With short-term investments, speculators seek to make huge profits.
Arbitrageurs operate in a unique and fast-paced way, with the ability to make quick judgments in order to maximize profits while mitigating the risk factor.
They are the investors who seek to improve market liquidity by making the majority of arbitrage possibilities available for a set period of time.
When such changes arise, they instantly acquire or sell derivative instruments such as Futures contracts. They only trade when there is a good prospect of profit and a low-risk profile.
When arbitrageurs discover any time-bound pricing disparities for a specific stock, they produce the best potential result.
A margin refers to the amount you must deposit with your broker to engage in the derivative market.
It is used to represent your daily losses and profits as a result of market fluctuations. It allows you to get leverage in derivative transactions while maintaining a big open position.
Always keep in mind that a little price shift will result in larger gains/losses than in the stock market in the derivative market.
What are the Advantages of the Derivatives Market?
There are countless benefits of trading in the Derivatives market as it offers a large pool of underlying assets.
Here are some of the benefits of the derivatives market:
Hedging Risk Exposure:
The contracts are typically used for hedging risks as the value of the derivatives is tied to the value of the asset.
For instance, an investor may buy a derivative contract whose value swings in the opposite direction of the value of an asset they own. Profits from the derivative contract may be used to cover losses in the underlying asset.
Determination of the underlying asset price:
The price of the underlying asset is typically determined through derivatives. For instance, Futures spot prices can be used to approximate the price of a commodity.
Effectiveness of the market:
Derivatives are thought to improve the efficiency of financial markets. This is because one can imitate the payout of assets by utilizing derivative contracts.
To eliminate arbitrage possibilities, the underlying asset prices and the corresponding derivative tend to be in equilibrium.
Access to Large Pool of Assets:
Derivatives can help investors get access to assets or markets that might otherwise be unavailable. For example, interest rate swaps allow a company to get a better interest rate than it might get via direct borrowing.
What Are Some Disadvantages of Derivatives Markets?
Despite the benefits that derivative markets offer, they also have some substantial disadvantages:
Derivatives’ extreme volatility exposes them to potentially massive losses. In addition, the complex structure of the contracts makes valuing them exceedingly difficult. As a result, they are exposed to a high level of danger.
Derivatives are often seen as speculative instruments. However, unreasonable speculation can result in significant losses due to the inherently dangerous nature of derivatives trading and their unpredictable behaviour.
Although derivatives traded on exchanges often undergo a comprehensive due diligence procedure, certain over-the-counter transactions may not have a due diligence baseline. As a result, there’s a chance of counter-party scams.
Market’s Sensitivity and Volatility:
Because of its extreme volatility, the derivatives market is avoided by many investors and traders.
Most financial instruments are extremely sensitive to tiny changes in the expiry time, interest rates, and other factors, making the market extremely volatile.
The derivatives market is frequently seen as an extremely difficult subject matter due to its high-risk nature and sensitivity. Because derivatives trading is so difficult to grasp, the general public tends to avoid it.
What are the Types of Derivative Contracts?
Derivative contracts are divided into four types of financial contracts: Futures Contracts, Options Contracts, Forward Contracts, and Swaps Contracts.
Let’s understand the types of derivative contracts more briefly:
Options are a type of derivative contract that provides the right to purchase or sell an asset at a defined price within a certain time period.
The buyer is not obligated to execute their option. The strike price is the price at which derivative contracts can be bought or sold.
Before the expiration of the option period, you can exercise the US options at any moment. On the other hand, European options may only be exercised on the expiration date.
Forwards contracts are quite similar to futures contracts in that the contract holder has the right and duty to carry out the contract as agreed.
But what makes it different is that Forward contracts are unregulated and unconstrained by particular trading rules and regulations because they are over-the-counter products.
Due to the unstandardized nature of such contracts, they are traded over the counter rather than on the exchange market.
Because the contracts are not governed by the norms and regulations of a regulatory agency, so they are customized to meet the demands of both parties.
Futures are standardized contracts that allow the holder to purchase or sell an asset at a predetermined price on a future date.
The futures contract parties are obligated to fulfil their obligations. The stock market exchange is where these contracts are exchanged.
The future contract’s value is marked to market on a regular basis. It implies that until the contract’s expiration date, the contract’s value is changed in accordance with market changes.
Swaps are financial derivative contracts in which two parties exchange financial commitments. The cash flows are based on a principal amount, which is agreed upon by both parties, with no actual principal exchanged.
A rate of interest determines the number of cash flows. One cash flow is normally constant, while the other fluctuates based on a benchmark interest rate.
The most frequent type of exchange is an interest rate swap. Swaps are over-the-counter arrangements between corporations or financial organizations that are not traded on stock exchanges.
How to Start Trading in the Derivatives Market?
To start trading in the derivatives market, here’s a step-by-step guide. Through this guide, you can successfully trade in the financial markets.
- Before starting to trade derivatives, you must first understand and learn how they work. The strategies used in derivatives are not the same as those used in the stock market.
- Now is the time for the main step: Yes, you heard it right! The most crucial step in derivative trading is to open a trading account with a reliable broker such as InvestBy.
- Once the account opening procedure completes, you must first deposit a margin amount. Until the trade is executed, the margin money cannot be withdrawn. Furthermore, if the quantity goes below the minimum, you must restore it.
- You must examine elements like cash on hand, margin requirements, the contract price, and the price of the underlying shares when choosing stocks. Make sure everything is in line with your budget.
- To settle the trade, you might choose to stay invested until the expiration date. In this case, you have two options: pay the whole amount or engage in a counter-trade.
Derivative Market in India:
The Indian derivatives market began in 2000 when the NSE and BSE began trading equity derivatives. Since then, the market has grown to its full potential.
India’s derivatives market has a long history, dating back to 1875. This year, the Bombay Cotton Trading Association began trading futures. According to history, India had become one of the world’s major futures trading markets by 1900.
However, once India gained independence in 1952, the government of India made cash settlement and options trading illegal. In the year 2000, the restriction on commodities futures trading was lifted.
It was made feasible by the establishment of the National Electronics Commodity Exchange. In addition, the National Stock Market, an electronic-based trading exchange, was established in 1993.
The Bombay stock exchange had been in operation for nearly a century at the time. Forward trading was available on the BSE, but derivatives trading did not begin in its current form until 2001. On June 12, 2000, the NSE began trading CNX Nifty index futures based on the CNX Nifty 50 index.
Today, Derivative securities are used in the Indian derivatives market to facilitate trade. Forwards, options, futures, and swaps are examples of derivative securities or instruments.
That’s all in our detailed overview of the derivatives market; here’s a quick summary of the topic –
Derivatives are financial instruments and financial contracts that derive their value from the value of underlying securities. Stocks, currency, commodities, and bonds are examples of underlying securities.
By assisting investors in discovering present and future pricing, derivative markets have played a significant role in the economy.
Market transaction volume has grown as a result of their efforts. The market has aided investors in managing the risk associated with the market’s ever-changing pricing.
On the other hand, derivatives are complex financial products, and trading in them requires a certain level of expertise and experience. So, we advise you to first learn and understand the basics of the market before entering.
Who can Trade-in Derivatives Market?
Participants in the derivatives markets may be classified into four groups based on their trading motivations. The list includes hedgers, speculators, margin traders, and arbitrageurs.
Where can I Invest in the Derivatives Market?
Derivatives can be purchased over-the-counter (OTC) through a brokerage-dealer network or through a brokerage platform like InvestBy. The broker offers a large pool of underlying assets by which you can invest in the derivatives market. Read a detailed review of InvestBy here.
What is the Difference between Spot Market and Derivative Market?
In the Spot market, you purchase or sell the real asset in spot markets, but in the derivative market, you buy a contract whose value is generated from the underlying asset’s price in the spot market.
In other words, market participants’ buy and sell orders influence the asset’s price in spot markets and, as a result, the contract value in derivatives.
How does the Derivative market Work in India?
In India, you may trade derivatives on the National Stock Exchange (the NSE) and the Bombay Stock Exchange (the BSE). Similarly, MCX and NCDEX are available if you want to trade in commodities.
What is the Difference between Derivatives and Stock?
The capital contributed to a firm by its owners is referred to as equity. This capital can be contributed in the form of a cash contribution or the purchase of shares.
On the other hand, a derivative is a financial instrument whose value is determined by the movement or performance of one or more underlying assets.
How Big is the Indian Derivatives Market?
The daily average turnover of the Indian Derivatives market has surged by 4.2 times in the recent decade, from Rs 33,305 crore in 2011 to Rs 1,41,267 crore in 2021.