What is Derivatives in Stock Market?

Derivative meaning in the stock market means a contractual agreement whose value is derived from an underlying asset like stocks, commodities, currencies, or indexes. These instruments give investors an opportunity to make trades based on projected price movements without actually purchasing or selling an asset. It is used to hedge and make strategic trades, and with increased awareness of finances and advancements in digital trading mechanisms, derivatives have become more accessible. This article explains what is derivatives in stock market. 

Example of Derivatives Market 

Let’s see an example of a future and an option contract of derivative market. 

• Futures Contracts 
  An investor decides to enter into a future contract for buying or selling a particular amount of a certain underlying asset at a predetermined price at a future date. Future contracts are generally utilised for security purposes as well as for trading. 
• Options Contracts 
  Options give the holder the right, but not the obligation, to buy or sell an underlying asset for a fixed price called the strike price during a specified period of time. An option can be used by the company to hedge its risk against commodities by buying or selling crude oil future or against exchange rate variations by entering into a contract. 

How Derivatives in the Stock Market Work? 

Here is how derivatives in stock market work: 

• First of all, at least two parties enter into a financial contract that has a value based on an underlying asset. 
• This fundamental asset may be a stock, bond, commodity, currency, interest rate, or market index. 
• The value of the derivative changes depending on the market prices of the underlying asset. 
• The derivatives are used by the investors for hedging, for the purpose of speculation on future prices, or for leverage. 
• These contracts are carried out either on a regulated exchange or through an over-the-counter (OTC) market. 
• Exchange-traded derivatives offer transparency and reduced risk of counterparty default, whereas OTC derivatives involve private agreements. 
• While exchange-traded derivatives are more transparent and less risky when it comes to counterparty risk, OTC derivatives are negotiated privately between two parties. 

Types of Derivatives 

The following are types of derivatives that traders can invest in: 

• Futures Contract: A Futures contract is an obligatory contract between the buyer and seller of an underlying asset. It means both buyer and seller must honour the contract. On the contract execution date, the buyer decides to buy an asset at a predetermined price, and the seller agrees to sell the asset. 
• Options Contract: It is a non-obligatory contract between the buyer and seller of an underlying asset. It means both buyer and seller can exit the contract at any time. The specified price agreed upon by both parties is referred to as the strike price. The option seller is also known as the option writer.  
• Forwards Contract: Similar to a futures contract, it is an obligatory contract between the buyer and seller of an underlying asset. Forwards are not traded on stock exchanges and are unstandardised, unlike futures and options. Through over-the-counter deals, investors can buy forwards. Also, both parties can customise the forwards contract.  
• Swaps Contract: Swaps happen through over-the-counter deals between financial institutions and businesses. The cash flow depends on a notional principal amount and not a real principal. Generally, swaps take place in the currency segment of stock exchanges. 

How to Trade Derivatives? 

Following the steps below, investors can trade derivatives: 

• Step 1: Investors need to open an online trading account. Investors can take orders over the phone or online if they are trading derivatives through a broker. 
• Step 2: Pay a margin amount. Derivatives cannot be withdrawn until the end of the contract, and the trade is concluded. Suppose, while trading, the margin goes below the minimum permissible amount; the investor will get a margin call to rebalance it. 
• Step 3: Keep the budget in mind, sufficient to cover margin for trading, available cash, and contract prices. Alongside, investors must ensure that they are aware of the underlying assets to avoid any financial inconvenience. 
• Step 4: Investors should stay invested until the trade is resolved, be consistent, and make informed decisions to reach a financial goal. 

Advantages and Disadvantages of Derivatives

The following table highlights the advantages and disadvantages of derivatives in the share market: 

Disclaimer : All investments are subject to market risks, economic conditions, regulatory changes, and other external factors. Returns are not guaranteed and may vary based on market performance and investment tenure. Investors should assess their risk tolerance and financial objectives, conduct their own research, and consult a qualified financial advisor before making any investment decisions. 

Conclusion 

Derivatives play an important role in the stock market in controlling risk, protecting prices, and participating strategically in asset classes. While they provide various benefits such as hedging and cost-effectiveness, they are also complex and carry risk.  However, with growing access to online trading app, investors can conveniently trade in derivatives.