For anyone who is planning to invest in shares, and for anyone who has recently started investing in shares, “derivatives” is a very fascinating market. We come across thousands of stories of people gaining huge profits by investing a really small amount in derivatives. These attractive stories captivate the minds of those people and they end up investing in derivatives without giving a thought to the repercussions of the same. They forget the simple principle that rules the entire stock market – “Risk and Reward go hand in hand” or you can reframe it as – “high return means high risk”. This is the main reason why people fail to make money in derivatives. In fact, they end up losing a huge amount and in some cases even end up losing an amount more than they can bear.
Having worked in the derivatives market, it is always advisable to have a basic understanding of how the “derivatives” function, what are the risks associated, what is the scope of the market, areas that can be tackled as per your requirement, and most importantly, the amount of risk or loss that you can bear. Once you are clear about these factors along with the basic understanding of the various terms associated with the market, you can invest your money for real in the market.
Please note that this is my personal advice based on what I have learnt so far and this advice will not eliminate or mitigate the risk factor. It will just make you aware of the risks and help you, and to some extent guide you on investing an amount such that the amount of risk/loss associated can be borne by you.
Now that I have hopefully been able to caution you about the risks associated with “derivatives”, let us gain a basic knowledge about the market.
In this blog I will cover the following questions:
- What are derivatives?
- What are the types of derivatives available in India?
- What are the basic terms (with meaning) associated with derivatives?
- How does the derivative market function in India (in simple terms)?
What are derivatives?
A derivative literally means “something which is based on another source”. In the stock market, a derivative is a financial instrument. It is a contract between two parties. The value of the contract is derived from an underlying asset. Underlying assets can be stocks, currencies, commodities, interest rates, or indices on which the price of the derivative’s contract is based. Summing it up, “a derivative is a contract or a financial instrument that derives its price or value from an underlying asset or an underlying financial instrument.”
What are the types of derivatives available in India?
- Forward – It is a non-standardized (not controlled by the authority) form of customized contract between two parties to either buy or to sell the asset at a predetermined price and date.
- Future – It is a standardized (controlled by the authority) form of financial contract between two parties that imposes an obligation on the buyer of the contract to buy the asset, and the seller of the contract to sell the asset at a predetermined price and date.
- Option – It is a standardized form of financial contract between two parties that gives the right but not the obligation to the seller to sell and the buyer to buy the asset at a predetermined price and date.
- Swap – It is a contract through which the two parties to the contract can exchange cash flows or liabilities at a predetermined date or dates.
- Warrant – It is a derivative that gives the right, but not the obligation, to buy or sell a security, most commonly an equity, at a certain price before expiration. Unlike options, warrants are issued directly by the company.
- LEAPS – Long-term Equity Anticipation Securities (LEAPS) allow investors to gain exposure to a specified stock without having to own or short sell shares of the underlying stock.
- Basket Option – It is a type of financial derivative where the underlying asset is a group, or basket, of commodities, securities, or currencies.
- Swaption – It is a combination of Swap and Option where the parties to the contract have an option or the right but no obligation to exchange the cash flows or liabilities.
What are the basic terms (with meaning) associated with derivatives?
You can use the derivative glossary as and when you come across various terms. Of all the websites I have gone through, I found this to be the best derivative glossary – https://www.finpipe.com/derivative-concepts-a-to-z/. If you have any other website better than this one please feel free to post the link in the comment section for other readers.
How does the derivative market function in India (in simple terms)?
Pre-requisites to Invest in derivatives:
- Dmat or Dematerialisation Account: This is the account which stores your securities in electronic format. It is unique to every investor and trader.
- Trading account: This is the account through which you conduct trades. The account number can be considered your identity in the markets. This makes the trade unique to you. It is linked to the demat account and thus ensures that your shares go to your demat account.
- Margin maintenance: This pre-requisite is unique to derivatives trading. While many in the cash segment too use margins to conduct trades, this is predominantly used in the derivatives segment.
Unlike purchasing stocks from the cash market, when you purchase futures contracts you are required to deposit only a percentage of the value of your outstanding position with the stock exchange, irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money, covers an initial margin and an exposure margin. These margins act as a risk containment measure for the exchanges and serve to preserve the integrity of the market.
You are expected to deposit the initial margin upfront. How much you have to deposit is decided by the stock exchange.It is prescribed as a percentage of the total value of your outstanding position. It varies for different positions as it takes into account the average volatility of a stock over a specified time period and the interest cost. This initial margin is adjusted daily depending upon the market value of your open positions.
The exposure margin is used to control volatility and excessive speculation in the derivatives markets. This margin is also stipulated by the exchanged and levied on the value of the contract that you buy or sell.
Besides the initial and exposure margins, you also have to maintain Mark-to-Market (MTM) margins. This covers the daily difference between the cost of the contract and its closing price on the day of purchase. Thereafter, the MTM margin covers the differences in closing price from day to day.
Above only explains the “margin” function of derivatives. It has a number of other aspects like time value of money and premium that are more complex in nature.
Read more about the time value of money on https://www.business-standard.com/article/markets/time-value-of-money-118062600365_1.html
Read more about the premium and settlement mechanism of derivative contracts at NSE on https://www.nseindia.com/products/content/derivatives/equities/settlement_mechanism.htm
However, both the concepts can be understood better when you practice it live either through dummy trading websites or taking the risk to trade with real money. And this is not all. As and when you start trading (dummy or real), you learn a lot of things.
I personally recommend you to start reading newspapers and stay updated about the sector in which you will be interested in trading before you start trading. Also, get a basic understanding of technical charts and fundamental analysis of stock markets if you wish to directly start investing in derivatives. You can read about stock market analysis in my previous blogs: