What are derivatives? And how do I invest in them?

A derivative simply can be said as a financial contract between two parties for the exchange of goods or money at a certain date with defined rule and cost involved in the transaction. The value of the financial instrument is derived from underlying assets (stocks, indices, commodities such as like gold, silver, oil, natural gas, electricity, wheat, sugar, coffee, and cotton, etc., currencies, exchange rates, or the rate of interest). Therefore, the market value of a derivative contract depends on the price of these underlying. If the price of underlying assets will increase/decrease the market value of the contract will also increase depending on the conditions of the agreement. Investors gamble on the future value of these underlying assets. For instance, let’s take an example, butter is a derivative of milk. The price of butter fluctuates based on prices of milk Vis a Vis its demand and supply. Initially, derivative contracts were the future contracts, farmers, and traders used to hedge their position or produce against price fluctuation. It can be said as insurance and works on the principle of risk transfer.

Different types of derivatives contracts are futures, forwards, options, and swaps.

What is a Forward Contract?

A forward contract is a non-standardized contract between two parties at a future date at a pre-agreed price. These are private contracts and depend on the understanding (terms and conditions) of these two parties and there is a high risk that any party can default on its sides of agreements since these are unregulated, no one can claim. Forwards are traded in the over-the-counter (OTC) and the terms of forwards are negotiable.

What is a Futures Contract?

A futures contract is standardized and the buying and selling of instruments happen through an exchange. The two parties are legally bounded to buy or sell the security at the expiry date of the contract at the same price. The details of the contract are standardized in terms of quality (commodity), quantity, delivery time, and place for settlement. The contract can either be settled by delivery of underlying asset/ cash on expiry or sold at any time by offsetting (opposite position) before they expire. To enter into a futures contract you have to deposit a percentage of total contract value (initial margin) into account.

What is an Option Contract?

Options Contract gives the option holder the right but not the obligation to buy/sell the underlying asset at a specific price within or at end of a specified period. The right is purchased from the seller/writer by paying a consideration called ‘Premium’ to lock in the strike price.

Options are of two types

Call Option: An option contract gives the holder the right to buy a stock at a specific price/strike price on or before a certain date asset from the writer or seller. 

Put Option: Option contract gives the holder the right to sell a stock/underlying asset at a specific price/strike price on or before a certain date to the underlying asset to the writer. An option issuer is obligated to buy the option at the strike price.

Further, an option contract can be divided based on when they can be exercised. An American option gives the right to exercise any time on expiry or before expiry; on the other hand, the European option can only be exercised on the expiry date. There are different types of options also. In Indian markets, the NSE stock options are American style whereas index options European style.

What is a Swap Contract?

Swaps can be said as an exchange. Two parties or counterparties agree to exchange their obligations to concerning their underlying assets or for simplicity let us says a series of future cash flows over a period in the future. There are different types of Swaps basic ones are currency swaps and interest rate swaps.

Different market participants in the derivatives segment are hedgers, speculators, margin traders, and arbitrageurs.

Financial markets are complex and interconnected. In the ecosystem where every economy is linked to other economies to some extent, derivatives allow businesses and investors to protect themselves from a change in price fluctuations and any negative news. India’s journey in the development of the derivative sector has been significant and has surpassed the equity market in turnover.

In terms of trading volume, NSE has become the world’s largest exchange beating the US-based CME group. However this is not an ideal scenario, derivatives should be used as a risk management tool to hedge your portfolio. Regulatory bodies should focus more on market development coupled with a proper framework for risk management because if not handled properly, it can be a greater source for major losses if the market bursts. Forwards and futures tells an important piece of information for finding the spot price (futures market) of an asset as well as expected spot price in the future.

Key measures you should know while applying derivatives

Goal strategy-Establish a strategy with set objectives for example the cost associated with the transactions, right exposure as well as profits. 

Risk Management-An appropriate risk management should be carried out to achieve certain objectives and should be mainly used to hedge your portfolio.