What are Derivatives?

If you have been trading in the markets or are just interested in stock trading, you will be familiar with the word ‘derivatives’.

So let's look at what is derivatives market. We will cover financial derivatives meaning, uses of derivatives, types of derivatives, and the risks involved in using them. Read on to know.

As the word suggests, derivatives are financial instruments that derive their value from another instrument.

Imagine a farmer who has sown a wheat crop that will yield 100 kgs. The farmer signs an agreement with a trader: two months later, when he harvests the crop, he will sell it at Rs 50 per kg for a total deal worth Rs 5,000. Now for the trader, the value of his deal depends on the price of wheat, the underlying commodity. Between now and two months, should the price of wheat rise to Rs 60, the trader’s agreement is actually netting him a value of Rs 6,000.

Bottomline: By entering into the agreement for a future transfer of an asset whose price will fluctuate in the future, the parties have turned it into a “derivative”.

In financial markets, exchanges create standardized derivatives contracts for buyers and sellers. When we say they are standardized, we mean that unlike in the farmer example above, where the buyer and seller could negotiate the price, exchanges offer contracts where the quantity and price are fixed. The standardisation helps creates volumes for a reason we will discuss below.

Types of derivatives

There are multiple types of derivatives market. The common types of derivatives created by exchanges are futures and options. In India, this segment is also referred to as F&O.

There are also other types of derivatives, such as forwards and swaps, but these are typically not standardised and hence not traded on mainstream exchange segments.

In a futures contract, a seller could promise to sell a fixed quantity of a particular stock (the underlying) to the buyer at a particular price on a particular date and vice versa.

Now would a buyer or seller want to buy or sell a futures contract on a stock, you might ask?

For the same reason that many people buy and sell stocks: for speculation (and profit). Buying and selling futures allow you to speculate in ways that you can’t for an equity stock. For one, these contracts have leverage built into them, meaning if the trader’s view panned out, they would make more profit per unit of price movement.

The other instrument is an option, where the contract gives its buyer the “right but not the obligation” to strike a particular deal in future. For instance, do you think a particular stock will rise in future? You could buy a “call option”, which will allow you to buy the stock at its current price in future. You will just have to pay a small premium, which will be a loss if the stock does fall or does not rise. We will learn about options in the next module.

Benefits of derivatives 

The derivatives market popularity such as futures and options has risen sharply over the past few years, with many traders coming to the market hoping to make a tidy sum.

There are a few reasons why traders love derivatives or F&O in particular.

One; because F&O has an inherent element of leverage built-in, traders stand the chance of making a large profit. Of course, since leverage can act as a double-edged sword, it also means that losses can also be large.
Two; many new traders come to the market with a small capital and want to try their hand at trading as a means of generating regular income. They try to offset the downside of having small capital, and consequently the limitation of making a small income, by taking on riskier trades, such as in futures and options.

For instance, a trader may come to the market with Rs 1 lakh or Rs 2 lakh. Now, for them to consider trading as an activity worth their time, it’s logical that they will need to be able to earn at least Rs 20,000 or Rs 30,000 monthly.

Now there are three things you need to know about the above situation:

• While wanting to earn Rs 20,000 a month is a reasonable expectation per se, in the context of their Rs 1 lakh capital, it is a monthly profit of 20% -- a very high figure.
• Such a return can be had only by taking a lot of risks in F&O
• Since most newcomers don’t realise the risks they are taking, they tend to lose money sooner or later

Are derivatives risky?

Yes, derivatives are risky in the same way a knife is: you need to be skilled at using it, or you will hurt yourself.

In fact, the flexibility that F&O offers actually even allows you to reduce or even eliminate your risk entirely, something no other segment offers. This will, of course, come at the cost of returns.

But what you need to know about F&O is that traders who do the following can be successful:

• Invest time and effort in learning how it works
• Are mindful of the risks that are associated with it
• Start small and learn from their mistakes
• Build a trading system that relies on mechanical rules rather than takes emotional decisions

Over the next few modules, you will learn the ins and outs of futures and options. This will help give you an edge, but whatever skills you learn here, you will have to keep the above four rules in mind in order to be successful.

Good luck!

Points to remember:

• Derivatives market cover financial instruments that derive their value from an underlying security.
• Futures and options are two common contracts in a derivatives market.
• Trading in derivatives carries significant risks.