Derivative Trading

Derivative Trading is one of the most interesting forms of trading that bring excitement to the space of stock market investments. A lot of variables apart from the stock price or market trend are in place while you indulge in this trading form.

Let’s discuss at length about how it works for traders while starting with the basics!

Derivatives at the financial contracts that derive their value from the underlying assets. The underlying assets, in this case, can be equity, commodities, indices, currencies, rate of interest or exchange rates.

The value of a derivative depends on the value of its underlying asset, thus by predicting the future price of the asset, the future price of the derivative contract can be judged and traded on.

Derivative Trading Meaning

Derivatives are one of the most complex financial instruments, and the most rewarding ones too.

Derivative Trading is the trading mechanism in which the traders enter into an agreement to trade at a future date or at a certain price, after understanding what the future value of the underlying asset of the derivative is expected to be.

Derivative Trading is a perfect place for both long-term investors and short-term speculators.

It is a normal buy and sell process, but instead of paying the entire money only an initial margin amount is paid to the stockbroker and the balance can be paid on settlement.

Derivative Trading can be of the following types, depending upon the conditions of the contract:

• Futures Trading: The parties to a futures contract have an obligation to buy or sell the contract as a pre-defined price and time, and conditions remain standardised.
• Forward Trading: The parties to a futures contract have an obligation to buy or sell the contract as a pre-defined price and time, but the conditions are customised by the buyer and seller according to their requirements.
• Options Trading: The buyer of the options contract does not have an obligation, but an option to buy or sell the security at a pre-defined time and price.
• Swap Trading: One cash flow is fixed and the other is variable and based on an underlying like interest rate, currency exchange rate or index price.

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Derivative Trading Example

As mentioned above, derivative trading is of multiple types and each type has its own set of rules towards trade execution.

Let’s take an example of futures trading under this form of investment so that you can easily grasp the concept.

For instance, let’s say recently the Indian government came up with a policy to subsidize the power sector in terms of their imports. This policy will have a direct impact on the production of Petroproducts as the producer can now import more raw material within the same cost.

This will increase the revenue of these businesses, thereby, increasing the overall profitability of the companies within that sector.

So, you pick up one such stock, let’ say ‘Relco Petro‘ which is currently trading at a market price of INR 660.

You are totally bullish towards this industry and the stock. You think that the stock will hit 900 by the end of the next month. With this in your end, you go into a futures contract with a seller at 750.

This implies that if the stock goes beyond 750 from the current market price of 660, you will be in profits.

To get into such a contract, you are required to pay a specific premium amount that works as an incentive for the seller and also shows your commitment towards the contract. Let’s say, this non-refundable premium amount, in your case is INR 2000.

From here, there can be 3 situations:

1. ‘Relco Petro‘ stays at around 660
2. ‘Relco Petro‘ drops to 600
3. ‘Relco Petro‘ jumps to 820

If either of the case (1) or (2) is true, then you will not exercise the contract and let it expire. In simpler terms, you will not ask the seller to sell the contract at 660 as its already available in the market at a better price.

In that case, your premium of INR 2000 will also be kept by the seller.

However, if (3) comes out to be true, then you will definitely want to exercise the contract by buying the stock at INR 660 and sell it later at a price of INR 820, thereby, making a huge profit on your trade.

This is how derivative trading works where you can be a buyer or a seller depending on your expectations from the market or a stock.

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Derivative Trading Strategies

Depending on whether you are using options or futures form of derivative trading and even within that, whether you are going for put options, call options etc, there are multiple strategies that can be deployed.

Some strategies come with mild risk while others bring in very high risk based on the market volatility.

At the same time, a few strategies come in with limited profit potential while there are some that come up unlimited profits too.

Here are some of the most commonly used derivative trading strategies:

• Covered Call
• Protective Call
• Long Call
• Bull Call Spread
• Long Strangle
• Short Strangle

There are 100s of other strategies that can be applied in your derivative trading. Thus, it is strongly recommended that you understand some of the major ones and start applying those in your trades to see the difference in your takeaway profits.

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Derivative Trading Tips

If you are relatively new or even an old-time in derivative trading, here are a few tips that MUST always consider while performing this form of trades:

• Keep your eyes wide open while looking at parameters such as strike price, premium, expiry date, current market price (CMP) etc.
• Use margin as per your risk appetite only. You might be looking to jump your profits but it can hurt your trading capital as well in case the market goes south.
• Do not trade a contract that you do not understand. Knowing the fundamentals and asset movement is the basic that you must be in the know of.
• If you are a beginner-level trader, start small. Do not fancy high expectations looking at what other traders are doing and saying.
• Invest in options as a small percentage of your overall investment portfolio if you are an initial-level trader.

These tips will not only help you to limit your losses but also amplify your profits as well.

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Derivative Trading Timing

Stock market trading happens with a specific time period on a business day.

As far as derivative trading is concerned, different exchanges such as NSE, BSE provide this form of trading on weekdays. It is not allowed on weekends (Saturday and Sunday) as well as on National Stock Market Holidays.

Here are the details on the timing of derivative trading:

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Derivative Trading Advantages

Derivative Trading offers many benefits to the traders and is an effective way of trading. Some of the advantages of trading in derivatives are as follows:

Hedging:

Derivative Trading is an excellent means of hedging, which means that the trader protects himself against the price fluctuations in the underlying securities. In order to reduce the risks related to price fluctuations in the current market, counter-position can be taken in the futures market.

For example, if a trader holds the shares of IBM and is expecting the prices of the shares to go down due to an external event, derivative trading can be used to sell IBM stock futures and thus hedge the losses.

Similarly, a trader can also take a counter-position in the index related to his portfolio, say Nifty 50, and make a profit by squaring off his short position.

The profit will compensate for the loss that he suffered due to the fall in prices of his securities. Also, derivative trading is used to hedge against price volatility in the currency markets by the importers and exporters.

If rupee falls against the other currency, say dollars, the imported goods become expensive and these losses to importers can be cut by using derivatives with currency as an underlying asset.

Leverage:

Derivative Trading provides the investor with an opportunity to pay only small values of the entire contracts as margins, and thus he can trade more than he has the capital for and make profits even with a small amount of capital.

Arbitrage:

Derivative Trading can be used to take advantage of the difference in price in different markets. The securities can be bought low in one market and sold high in the other market, leading to arbitrage profits.

Earning money on idle securities:

Even if the investor does not want to sell the shares that he bought for long-term, he can still take advantage of the price fluctuations by using derivative trading, as derivative trading does not require physical settlement.

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Derivative Trading Risks

Along with the extensive benefits that derivative trading offers, it has its own set of risks too. It is no exception to the fact that trading can result in unexpected losses and there are no guaranteed profits.

Some of the other associated risks with derivative trading are:

Market Risk:

You cannot be always right when it comes to trading (or in general as well:))!

Anyway, even if you put all your expertise in research and analysis before placing a trade, there are going to be instances when the market takes a U-turn and trends opposite to what you imagined.

Thus, with derivative trading that brings in an added risk factor(s), you need to be extra cautious, always!

Counter Party Risk:

When it comes to derivative trading, there are 2 parties involved who go into a contract with/without obligation (depending on the type of the derivative).

There is a possibility that one of the party backs out of the contract especially when it comes to over the counter or OTC markets.

Liquidity Risks

There are times when a trader wants to exit the trade before it actually expires. Now, if you do so, you must be ready for some extra costing/loss/lesser profit, whatever the case may be.

Can such risks be mitigated? Well, here is an example for you on how it can be done!

When it comes to the commodities segment, there are a whole lot of factors one needs to involve in. For instance, if you are a coffee shop, one thing that you need ALWAYS is Coffee Beans!

What if you think the weather may or may not be conducive in the next season?

In that case, you need to enter a futures contract with the supplier where you are required to pay extra just to play safe. Having said that, even if you paid a bit ‘extra’, you have kept your business completely safe from factors that are outside your control (or anybody’s control for that matter in this case).

Therefore, it is advisable for the investors to exercise caution and trade only based on their own risk appetite and financial conditions. It is not an appropriate avenue for traders with a low-risk appetite, limited resources and limited trading experience.

If you are looking to get started with share market trading, you can provide details in the form below.

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More on Share Market Education:

If you wish to learn more about derivative trading or the stock market in general, here are a few references for you: