What is Derivatives Trading?
The Term Derivatives trading seems complex, but in simple terms it is a contract between entities. The worth of this contract is based on a financial instrument underlying the contract, hence it is ‘derived’ from the base asset. The base product may be a share, a bond a commodity, or an index etc. Derivatives trading can also be understood as secondary instrument derived an underlying financial asset’s value.
Derivatives seem to be too risky and sophisticated for an unexperienced investor. The fact is that derivatives can actually act as a safeguard or insurance to protect against volatility of a share, portfolio or index.
Let’s take example of a farmer who anticipates that the price of his produce will fall in future. The price right now is Rs 100 per kg. To not lose money at a later date, he gets into a contract to sell the produce at a future date at Rs 100 per kg. The buyer on the other hand believes prices will go up and therefore agree to pay Rs 100 at future date in anticipation of profit. The contrarian view of the two parties, one will be wrong and create a hedge and profit opportunity.
There are various types of derivatives. Broadly they are categorised into options, swaps, futures, and forward contracts.
Swaps, futures, forwards oblige the parties to the terms till the end of the contract.
Option products provide the option to the buyer to enter the transaction agreed in the contract, but it is not an obligation.
Derivatives are bought and sold through an exchange as well as directly between parties.
Advantages of trading in derivatives:
Low costs: Derivatives are a risk management tool. The processing cost is low compared to other segments and asset class. In derivatives trade, there is no actual buying or selling of the instrument on which derivatives is based. The trade is done on the value alone.
Risk Hedge: Derivatives are an excellent tool to cover risk. This is the biggest benefit why investors trade in derivatives. The derivatives contract covers the risk due to movement in price of base security and limits the loss.
For example, in a forward contract, a buyer and seller enter into an agreement to execute the buy or sell at a future date at a pre-decided price. Therefore, the risk due to volatility in price of base security is limited.
Risk Transfer: Derivatives transfer the risk inherent in an underlying security from the buyer to the seller. Effectively, the parties exchange the risk based on differing view on the value of security. The risk appetite of one investor differs from other. Through Derivatives Contract, risk shifts from participant who wants low risk to the one who wants to take higher risk.
Market efficiency: Derivatives bring better market efficiency. Derivative contracts are based on expectations of profit on underlying securities. This brings an equilibrium in the expected price movement of a security and its actual movement, thus reducing the arbitrage and makes the markets more efficient
Derivatives also help in discovering the price of the base security. The spot rate in a contract gives an indication of the current price of the security. Derivatives help in understanding the price movements. Derivatives also help in predicting uncertain future events that impact the spot and future price of a security, e.g. debt default.
Speculation: Derivatives trading is considered risky and complex due to its speculative nature. The same feature is also an advantage if executed with reason. At times, derivatives are used for speculative trading, assuming that other party’s view is wrong about the price of base instrument in future. The price fluctuations provide an opportunity to speculate and earn profit.
Derivatives provide often allow investors to trade in assets which otherwise are not traded in open markets.
Yes, derivatives trading is more cost effective compared to other segments and asset classes.