Derivatives is an excellent investment and trading instrument for the courageous. The derivatives market presents fascinating opportunities to ride the market waves and make big profits. However, derivatives instruments are not like stocks, so you need to understand the types of derivatives in the financial derivatives market. This article enlists and explains the top types of derivatives in India to help you make better investment decisions.
Derivatives and Its Types - A Primer
If you know what stocks and indices are, you can understand derivatives and its types quickly. Assume that you have 1 lac rupee in your account and wish to purchase a stock worth INR 1000 apiece, you can buy 100 shares. However, if you enter the derivatives market, you can buy the same 100 shares at a fraction of the cost of 100 shares.
Derivatives refer to legal financial contracts that enable you to buy or sell an underlying asset, such as stock, index, commodity, currency, etc., on a pre-specified date at a predetermined price. While some derivatives instruments give you an obligation, others give you a right but not an obligation.
What Are The Types of Derivatives in the Financial Derivatives Market?
Here are the 3 types of derivatives you can find in the Indian derivatives market:
Futures and Forward Contracts
In essence, futures and forward contracts are two sides of the same coin. But, while forward contracts are traded over the counter, futures contracts are legalised contracts traded through a stock exchange, such as NSE. Both forward and futures contracts are derivatives contracts that enable the buyer to buy and the seller to sell derivatives contracts on a predetermined date at a predetermined price.
The credit risk is nil in a futures contract since the exchange acts as the counterparty. Also, since a futures contract is standardised, it cannot be modified, meaning that the price, expiry date, size and other specifics of the derivatives contract is clearly mentioned and agreed upon by both parties.
Unlike futures contracts, forward contracts are customisable and come with counterparty risks. Also, forward contracts do not require any collateral since they are self-regulated.
In a way, options contracts are similar to futures and forwards. However, they are also different. Unlike futures and forwards, you are not under any compulsion to discharge or honour the contract on the date of the expiry. Options contracts provide you with the right (not obligation) to buy or sell the contract on or before the expiry date. Options contracts are of two types - call options and put options. Call options provide the investors with the right to purchase the underlying asset at a predetermined price. In contrast, put options give investors the right to sell the underlying asset at a predetermined price. In both call and put options, the buyer can settle or close the contract anytime before the expiry. Hence, an options trader can take four positions in the derivatives market - long call, short call, long put, and short put.
Swap contracts are the most complex of the four types of derivative instruments. Swap contracts occur between two parties who agree to exchange the cash flow on a date in the future according to a predefined formula. Although there are many types of swaps, such as interest rate, currency, commodity, credit default, zero coupon, etc., interest rate swaps are the most common. Since underlying assets like currency or interest rates are typically more volatile than indices or stocks, swap contracts are often considered the riskiest derivative instruments. Swap contracts are executed through investment bankers since they are not traded through stock exchanges.
Trade in Derivative Instruments Like a Pro
Sensible and experienced investors use derivatives contracts, such as futures, forwards, options, and swaps, as a hedging cum investment instrument. 5paisa provides a free Demat and Futures & Options (FO)-enabled trading account to help you test your skills and ace the art of trading.