What are the Types of Derivatives

Derivatives are financial tools whose value is derived from an underlying asset, index, or rate. They are contracts between two parties, where the value fluctuates based on changes in the underlying asset. There are various types of derivatives, each serving different purposes in the financial markets. Common types include futures contracts, which involve the obligation to buy or sell an asset at a predetermined price on a future date, and options contracts, providing the right, but not the obligation, to buy or sell an asset at a set price.

Before we get into the specific types of derivatives in detail, the concept has to be understood. Derivatives are called so because they do not have any value on their own. They derive their value from an underlying asset like stocks, bonds, commodities or indices. When you are trading in derivatives, you are depending on these underlying assets, which determine the returns on derivatives. Let us look in detail at the types of derivative markets overall. 

What are Derivatives?

Derivatives are trading instruments which can be explained as the underlying asset, such as bonds, equities, market indexes, commodities, or currencies. These determines the value of derivatives or derivatives contracts. The value of these underlying assets is always changing based on the state of the market.

For example, let's say you bought shares at market value. If the stock price continues to fluctuate and loses value, losses may result. One option, in this case, would be to enter into a derivative contract. As an alternative, you may utilise futures as insurance against losses in the real stock market. These operate as a buffer against adverse price movements in the stock.

Types of Derivatives

Broadly, there are 4 different types of derivatives. Structurally, a forward and future contract is almost the same, although there is a subtle difference. However, in the case of options and swaps, the payoffs and the structure are entirely different. Let us look at each of these contracts in detail.

Forward Contracts

A forward contract is a contract between two parties to buy and sell an underlying asset at a fixed date and in the future. For example, a tomato farmer and a ketchup factory can enter into an agreement where the farmer supplies a fixed quantity of tomatoes to the factory, and the factory agrees to take up the quantity. If the price falls below the contract price, the farmer gains and the factory loses. Conversely, if the price is above the contract price, the factory gains, and the farmer loses. Forward contracts are highly customised and typically entered into between parties with specific needs. However, they are illiquid, and if one party cannot fulfil the agreement, the other party has only legal recourse. This liquidity and counterparty default risk is overcome by futures contracts, which address these issues.

Futures Contracts

The futures contract is similar to forward contracts, the only difference being that it is more structured. A futures contract is a similar agreement between two parties to buy and sell underlying assets at a fixed price and future date. If one party defaults, the exchange clearing house will fulfil the contract, unlike forwards, where the buyer and seller are anonymous.

Options Contracts

Options are asymmetric contracts with different rights for the buyer and seller. An option is a right to buy or sell an underlying asset, with the buyer receiving the right and the seller giving the right, not obligation. The premium is the price of the right, which is a sunk cost paid by the buyer to the seller. Options can be of two types: call and put options. Call options involve buying an underlying asset, while put options involve selling an asset. There are buyers and sellers of call-and-put options, and options have standardised strikes and expiries. Strikes are contract prices on which rights to buy and sell are traded in the market.

Swap Contracts

Among all the derivatives contracts, swap contracts are very complex. A swap means an exchange. A swap contract is about exchanging one set of cash flows for another set of cash flows. For example, if you are an exporter and expecting a stream of payment in dollars, you can swap it for payments in pounds or euros if that is more attractive. Similarly, if you have fixed interest payouts, you can swap them into variable interest payouts linked to a benchmark rate.

Swap contracts are over the counter (OTC) contracts and are not traded on exchanges. They are done privately between parties. Typically, the underlying assets in a swap contract are either the currencies or interest rates. Normally, such swaps are structured by specialists.

How to Trade in the Derivatives Market?

It's critical to comprehend both the various derivatives and the market dynamics before engaging in financial derivatives trading. Learn about the circumstances of the market as it stands now and the variables that might affect it. Economic, political, and social variables can all cause significant changes in the financial markets. It is essential to be aware of these developments and be ready for them.

Steps To Trade in the Derivatives Market:

• Open a trading account online.
• You must pay a margin deposit to begin trading derivatives; this money is locked in once the deal settles and the contract is completed. A margin call to rebalance the account will be prompted if the margin amount is less than the minimum necessary. 
• Make sure you understand the underlying asset well. It's also critical that the contracts have enough money to last until the deal is resolved.