For many people investment in the stock market refers to investment in stocks or mutual funds only. In reality, it includes much more than just stocks and mutual funds. An important component of the stock market is derivatives. These are complex investment options with higher risks and the potential to earn higher returns.
Given below are a few details of derivatives to help investors make better investment decisions.
Derivatives are secondary market investment options where the performance of an instrument is dependent on an underlying asset or group of assets. Derivative markets can include many types of assets like currency, commodities, exchange rates, indices, etc. The investor earns returns on these assets through the speculation of the future performance of an underlying asset.
Derivatives can be broadly classified into two types of market namely, exchange-traded derivatives and over-the-counter (OTC) derivatives. The former includes contracts that are regulated and managed by the market and have standardized contracts with a comparatively lower risk of default. OTC derivatives on the other hand are unregulated non-standardized contracts that do not have any intermediaries or any exchange to be traded on. These are flexible contracts that can be easily modified and hence carry huge risks.
Derivative markets consist of four major participants. Given below are a few details of the same.
Hedgers are the investors that invest in the derivatives market to eliminate the risk of any change in the future prices of the asset. The primary intention is to secure the existing exposure in the market or to reduce the risk and not to earn profits.
Speculators are traders who predict the prices of an asset or derivative based on the future movement of the underlying asset and take calculated risks to earn profits. It is the most common market activity.
Margin is the nominal percentage of the value of the investment to be deposited by the investor to cover the risk of the investment. Margin traders use this margin money to purchase more stocks.
Arbitrage is the activity of earning profit based on the difference in prices of an asset in two different markets. Arbitrageurs purchase an asset at a lower price in one market and sell it in another market at a higher price to gain profits.
The derivative market is essentially divided into four types of market instruments. These instruments are explained below.
These are standard agreements or a contract between two parties that are executed on the exchange market. Under this contract, the buyer or the holder of the contract has the right as well as an obligation to buy or sell an underlying asset at the agreed future prices.
Like futures contracts, options also provide the right but not an obligation to buy or sell an underlying asset at a future price. There are many types of options like American, European, etc which can be bought using call (option to buy) or put (option to sell) options
Forward contracts are similar to futures contracts with the only difference being that they are over-the-counter contracts and hence are not traded on any recognized exchange. The parties in the contract can customize the contract based on their needs and risk-return parameters.
Swaps are another type of over-the-counter instrument where the parties are allowed to swap or exchange their obligations. The most common type of swaps is the interest rate swaps along with currency swaps or commodity swaps, etc.
Derivative markets, although riskier than primary markets, have many advantages. Some of these advantages are discussed below.
Derivatives and an excellent option to invest in stock markets with limited capital. Investors can get attractive returns from lower capital investment as compared to primary investment instruments like shares and mutual funds.
The cost of investment in derivative markets is lower than the cost of investment in primary assets like shares and debentures. The reduced capital investment further decreases the cost of investment for the investors.
Derivative markets are an effective tool to reduce the risk of investment. The participants of the derivative market can hedge their risks and also gain the benefit of arbitrage along the way. This increases the potential returns for the participants of derivatives markets.
Another benefit of the derivatives market is the flexibility to trade in standard or nonstandard contracts. Participants can customise the contract to suit their needs and gain maximum returns at calculated risks.
After discussing the above advantages of derivatives markets, let us now discuss their limitations.
The first and foremost limitation of the derivatives market is the risk. These markets carry significantly more risk than primary markets. If the risk is not effectively managed, it can result in huge losses for the participants.
The contracts in derivatives markets are quite complex and need thorough market knowledge before participation. A novice person may end up losing more money than making some if they do not understand the functionality of these markets and the contracts entered by them.
Speculation is the key to these markets to maximize the returns. The unpredictability of these markets and the higher risks may lead to higher losses and can potentially drain all the capital investment of the investors.
Cash markets are the markets that trade-in cash for commodities or assets and receive them at the point of sale. This is the underlying difference between a cash market and a derivative market. Few other differences between the cash market and derivative markets are discussed below.
| Category | Cash market | Derivatives market |
| Lot sizes | In cash markets, investors can buy or sell in any quantity or even in single units | In derivatives markets, the lot sizes are fixed and single units are not available |
| Nature of assets | Cash market trade only in tangible assets | Derivatives markets can be used to trade in tangible or intangible assets. |
| Trading mode | In cash markets, investors need a trading and Demat account | In the derivative market, investors need only a future trading account |
| Dividends | In cash markets, the investors have the right to dividends | In derivative markets, investors have no rights on the dividends |
| Ownership | Investors have the ownership of the asset (share) purchased by them | Investors do not have any ownership of the asset purchased by them. |
There are several factors that investors need to be aware of while using derivatives. These factors are discussed below.
Derivatives are an attractive investment option for many traders with a high-risk appetite. It allows them to hedge their risk and gain the benefits of arbitrage. However, it is a high-risk game and the investors who do not take calculated risks or over-expose themselves can end up in the deep end and lose all their capital along the way. Hence it is advisable to have a good knowledge of these markets before plunging into them.
1. Can a person take multiple positions to hedge their risks?
A. Yes. Hedging is the key to risk management on derivative markets. Investors are allowed to take one or more positions in the market to hedge their risk and ensure maximum gains.
2. Is a demat account enough for derivative trading?
A. No. Investors will have to open a futures trading account for derivative trading. They will have to ensure that their broker allows derivative trading, if not, investors will have to approach a new broker that provides such facilities.
3. Can a person trade commodities in derivative markets?
A. Yes. Commodities are part of the derivative markets and their prices are dependent on many underlying factors like global trade, demand-supply forces, etc.
4. Are derivative markets more expensive?
A. No. Investment in derivative markets is lower than primary investment options and reduced capital investment further reduces the cost of investment.
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