Expert investors often juggle between cash and derivatives markets to maximise their returns from capital market investments. Derivatives offer several significant advantages over the cash market. Derivatives are usually more volatile than stocks and allow investors to hedge their market positions. Before understanding the benefits and types of derivatives, let’s learn what derivatives are.
What Are Derivatives?
Derivatives are financial contracts whose value depends on an underlying asset. The underlying asset can be stocks, bonds, indices, currencies, and commodities. The price of a derivative is set by two concerned parties, namely the buyer and the seller.
For example, if you plan to invest in gold derivatives, you have to find a seller selling gold derivatives and enter into an agreement to purchase the derivatives. Derivative prices depend on the movement of the underlying asset. In India, exchanges like NSE, BSE, MCX, NCDEX, ICEX, etc., facilitate derivatives trading.
What Are The Types of Derivatives?
Although there are many types of derivatives, the following four types are the most commonly traded in the market:
A futures contract refers to an agreement between the buyer and seller of an underlying asset. The buyer decides to buy an asset at a predetermined price on the contract execution date, and the seller agrees to sell the asset on the contract execution date. Futures is an obligatory contract, meaning the buyer and seller must honour the contract.
Like futures, options refer to derivative contracts that take place between buyers and sellers. But, unlike futures, options contracts are a right and not an obligation, meaning both parties can exit the contract at any time. However, if an investor wants to exercise their rights, they can do so. The option seller is also known as the option writer, and the specified price agreed by both parties is referred to as the strike price.
Forwards are much like a futures contract. Here, the holder of the contract is obligated to honour the contract. But, unlike futures and options, forwards are not traded on stock exchanges and are unstandardised. Investors buy forwards through over-the-counter deals. Also, the buyers and sellers of forwards can customise the contract.
Like forwards, swaps are not traded through stock exchanges and happen through over-the-counter deals between financial institutions and businesses. In swaps, the cash flow depends on a notional principal amount and not real principal. Swaps generally take place in the currency segment of stock exchanges. Now that you know of the various types of derivatives, learn about the benefits of derivative trading in the following section.
The Benefits of Derivatives Trading
Higher Profits Than Equity Trading
Derivatives trading is margin-based trading, meaning you need to pay a fraction of what you buy. Hence, the quantum of profit is often substantially higher than equity stock trading in the cash market.
Derivatives make it easy to find arbitrage opportunities. If you are an arbitrage trader, you buy financial instruments in one market, sell them in another market, and pocket the difference.
Derivatives protect you from volatility. For instance, you can buy an equity stock hoping it will rise and buy derivatives to cushion the impact if the prices fall.
A Demat Account is All Your Need to Trade Derivatives
5paisa makes derivatives trading as easy as ABC. Visit the 5paisa website to open a free Demat and trading account and start trading instantly. You can also access the educational resources published by 5paisa to sharpen your trading skills and make bigger profits.