Do you want to expand your stock market holdings? One method to boost your trading game is to become involved in the derivatives market. Just perform your due diligence upfront and learn the fundamentals of risk management in derivatives trading.
Types Of Derivatives
Four different types of derivatives contracts are traded by derivatives traders in India-
Futures: A futures contract is an agreement between a buyer and a seller to buy or sell the underlying asset by a specific future date. By the specified expiration date, both parties must honour the contract’s conditions. A regulated exchange is used for futures trading.Trading in futures and options requires an in- depth understanding of the underlying assets and market conditions to effectively manage risks and maximise profits.
Forwards Contract: Unlike a futures contract, a forwards contract is negotiated directly between the two parties. This makes it possible to tailor the contract more. Other names for forwards include over-the-counter (OTC) contracts.
Options: In a futures transaction, the contract conditions stating the expiration date must be honoured by both parties. A contract for options, however, operates somewhat differently. It gives one party the freedom to decide whether to execute the contract. With a call option, the buyer has the choice but not the responsibility to purchase the underlying asset by the expiration date. In the put option, the seller has the choice of whether or not to sell the underlying asset before the expiration date, but not the responsibility to do so.
Swaps: Swaps are transactions in which two parties exchange obligations or cash flows. The interest rate swap is a common illustration. Swaps are not commonly used by ordinary investors, and they are not typically transacted on an exchange.
Trading in futures and options, forward contracts, swaps requires an in- depth understanding of the underlying assets and market conditions to effectively manage risks and maximise profits.
Conditions To Fulfil For Trading Derivatives
Although derivatives trading is comparable to other types of trading, there are a few prerequisites that traders must meet before they may engage in derivatives trading:
1. First, you need to open demat account. A demat account, which is the account used to keep securities in digital form, must be active for a trader to do business.
2. To perform actual trades, traders need to open a trading account too. The trading account is linked to the demat account.
3. A fund equal to the overall value of the underlying asset must be deposited and maintained by traders. This procedure is known as margin maintenance. One has to do this every day according to the price changes of assets.
Participants Of The Derivatives Market
Not every trader engages in derivatives trading for the same objectives. Traders that engage in derivative trading can be roughly categorised into the following groups according to their objectives:
Hedgers: Hedgers are risk-averse traders who use derivatives trading to hedge against price changes. In order to do this, they fix the price of the underlying asset and assign risk-taking speculators responsibility for price volatility.
Speculators: Traders that take risks from hedges in order to profit from price swings are known as speculators. They provide the stock markets with a crucial source of liquidity.
Low-risk traders known as arbitrageurs try to make money by selling the same item at different prices in two distinct marketplaces.
Benefits Of Trading Derivatives
Trading in derivatives offers a variety of advantages that might satisfy the interests of different investors:
- Because derivatives serve as tools for risk management, trading in them has lower transaction costs than other types of trading.
- As price changes are already accounted for in contracts, derivative trading can be a useful instrument for protecting against them.
- By speculating on price disparities and volatility in several markets, traders of derivatives provide investors with the chance to take advantage of arbitrage possibilities and increase their earnings.
Disadvantages Of Derivative Trading
While trading in derivatives has many advantages for traders, it also has several disadvantages that must be managed for a trade to be successful:
- Derivatives are subject to price changes, which, if not effectively handled, can result in significant losses.
- Because contracts in derivatives trading are hard to terminate before expiration, traders are susceptible to market volatility.
- Trading in derivatives is restricted since it necessitates in-depth familiarity with intricate financial market procedures.
Conclusion
Derivatives allow individuals who have low-risk appetites to other players with high-risk appetites. Speculative transactions are moved from an unorganised market to an organised market with the use of derivatives markets. The exchange-traded derivatives markets are better regulated than the unofficial OTC markets.
Derivatives are a crucial instrument for risk management, and by improving their risk management, organisations may lower their risk and increase values. Options are also suitable enough to set up hybrid transactions with low risk, potential for revenue, low cost, etc. Some renowned financial firms like Kotak Securities offer excellent services to trade all kinds of derivatives at low charges. If the derivative market is your next share market destination, explore the various services on the Kotak Securities platform.