Derivatives Definition, Types, and Trading

Derivatives are financial instruments that investors use to transfer asset risks to other willing investors. The derivatives definition is such that it allows for a financial contract to exist between two parties. Each party has something to offer to the other one, and this is laid out clearly in the contract. For instance, if you have a stock that might devalue in the future, you use a derivative to transfer this risk to another party.

Derivatives Meaning

By definition, a derivative is a financial contract. Its value depends on an underlying asset or a group of assets. This contract is entered into by two or more entities that can trade with each other.

Derivative trading can be done on several assets, each with its individual risks. The fluctuations in the prices of the underlying assets determine the derivatives’ price. Derivative trading can give you access to certain markets. You may also trade them to hedge against risks. Depending on the types of derivatives, they can mitigate risk or assume risk. The former is called hedging, while the latter is called speculation.

Experts consider derivatives as an advanced form of investing. In this regard, the most commonly used underlying assets are bonds, commodities, stocks, interest rates, currencies, and market indexes.

Types of Derivatives

The derivatives definition becomes even more clear if you understand its different types. Depending on the contract, there can be four types of derivatives –

1. Options: The derivative definition for this type is that you can sell or buy an underlying asset at a fixed price in a given period of time. The buyer of the derivative, however, is not obliged to exercise the option. Option derivatives usually come with an expiry date. In the Indian market, options expire within weeks or months.
2. Future: Also called future deliver, this type of derivative allows you to buy or sell assets at an agreed-upon price on a specified date. These are standardized contracts whose values are marked to market on a daily basis. This implies that the profit or loss incurred by you or the other party is calculated and adjusted in their margin amount daily. Future contracts also have an expiry date which is typically a month in the Indian market.
3. Forwards: These are custom derivatives where the two parties decide a future date for the contract settlement. The buyer of the contract is under obligation to fulfil it. This renders it a similar derivative meaning as future contracts. Forwards are available over the counter (OTC), and are not marked to market. The risk involved for both parties is greater in forwards that in any other type of derivative.
4. Swaps: With a swap contract, you can enter into a cash flow exchange with another party. It allows you to facilitate cash flow exchange at a future date using a pre-planned formula. Swaps, however, are not traded on exchanges and are only available over the counter.

Derivative Trading

Derivative trading simply means buying and selling derivatives. It allows you to buy a large number of underlying assets as an investor by paying only the margin. Margin is the initial amount of money you would pay to buy a derivative. Through derivative trading, you can buy or sell stocks, commodities, or currencies.

Trading in the Derivatives Market

Now that you are clear about the definition of derivatives, take a look at how derivative trading works. To start, you will need,

• A Demat and trading account.
• Add enough money to the Demat account to match the margin required to buy and sell derivatives.

Derivative trading mainly involves four players –

1. Hedgers take part in derivative trading to eliminate future price change risks.
2. Speculators and traders predict future price changes.
3. Arbitrageurs exploit price gaps between multiple markets.
4. Margin traders use margins to increase their stock holdings.

Advantages and Disadvantages of Derivating Trading

If you engage in derivative trading by understanding the types of derivatives, you can benefit significantly. But there are also risks involved that you should be aware of.

Pros

The benefits of derivative trading are,

• Reduced market transaction costs: Unlike debentures and shares, the cost of derivative stock trading is much less. This is because derivatives act more as risk management tools.
• Risk management: Changing asset prices are associated with high risks. Derivatives can be used to mitigate this risk.
• Arbitrage: Derivative trading helps to achieve market efficiency by ensuring underlying assets reach their right prices.
• Asset price determination: Different types of derivatives are used to determine the prices of underlying assets.
• Transferable risk: Derivatives allow businesses and investors to transfer the risk associated with underlying assets.

Cons

Derivatives by definition are good. But there are critical demerits attached to derivative trading –

• High-risk trading: The prices of underlying assets are subject to market fluctuations. This makes derivatives a high-risk contract.
• Counterparty default: Derivatives that are sold over the counter bear a high potential of counterparty default as they are not regulated by market controls.
• Speculative: Derivatives meaning is speculative.

Derivative trading requires research and building in-depth knowledge about market assets. If you are interested in knowing more, then follow the Piramal Finance blog for information on related topics.