A Beginner's Guide to Derivatives Trading
I want to Trade in Derivatives in India. But What Are Derivatives?
As you get older, you realise the importance of health insurance. You could break a bone more easily. Or contract a lifestyle disease. Health insurance is an absolute must if you want to save on hefty hospital bills. Just like that, trading in the Indian financial markets could also be risky if you don’t have yourself covered. That’s where derivatives trading comes in.
Say you have invested in NIFTY 50 ETFs costing ₹17,800 per unit. You buy 56.17 units that bring your total investment to ₹10 lakhs. You invested in the index because you believe that it will mimic the average returns given during the last five years of about 14%. You intend to sell your position in two years to pay the downpayment for your new home.
However, at the end of two years, the ETF has a negative return of 15%, bringing your net holdings to ₹8.5 lakhs.
If you had bought derivatives to protect yourself from the downside, you would not have losses. How? Say, you had bought put options on NIFTY at ₹18,000 per unit. You paid a small premium for it. Upon expiry, you could have sold your NIFTY ETF position for a net value of ₹10,11,060. This may not be the returns that you had expected, but it would have covered your capital. Had the market performed as per your expectations and given you a positive return, you could have let the put option expire worthless. Your loss would have been limited to the premium that you paid.
This is how derivatives in finance work. Still confused? Don’t worry. Keep up with us and we’ll explain how you can reduce your risk or even make profit by trading in different types of derivatives.
What are Derivatives in Financial Terms?
Derivatives are usually thought of as complex financial instruments. In reality, they’re quite simple if you understand the mechanisms underlying them. There’s a hint in the name as to what derivatives are - they derive their value from something.
For instance, you could have a stock market derivative based on the price of stocks. Or, you could have a derivative on the price of commodities. Derivative contracts are built on top of an asset and move according to the price of the asset they are linked to. Derivatives trading can take place on stocks, indices, commodities, currencies, rates of interest, or exchange rates.
Like any other financial transaction, derivatives trading also requires a buyer and a seller. Usually, these parties must have an opposite view of the market. If they’re both betting on the same side, the contract won’t work. For example, if a futures buyer expects the price of a share to increase in the future, the seller must believe that the share price will fall. Why would the seller agree to sell at a lower price knowing it will rake up a loss?
Now, you may wonder what is a derivative market? It’s a marketplace where derivative contracts are bought and sold. This could be an exchange or an over-the-counter marketplace. Typically, futures contracts and options contracts are traded on exchanges and are the most common derivatives traded in India.
Types of Derivatives in Indian Markets
Indian derivative markets mainly deal in futures and options contracts. Like we’ve already said, futures and options are standardised contracts that are traded on exchanges. Let’s get into what both of these mean.
Futures contracts, usually called futures, are a type of derivative in which two parties agree on the purchase and delivery of an asset. The prices are fixed in advance and the date of delivery is also pre-decided. Futures can be drawn up on shares, indices, commodities and even weather movements!
When it comes to futures, here are some terms you should know:
Futures contracts have a minimum number of shares or commodities (or any other asset) that you can trade in. When you trade in a futures contract, you can only trade in the prescribed lot size or in multiples thereof. For example, the lot size on Nifty Futures is 50. You have to trade in at least 50 Nifty units or in its multiples.
Contract value means the lot size multiplied by the futures price. The futures price depends on the value of the underlying, moving in sync with the price of the underlying.
Trading cycle is the process of how derivatives contracts are settled. Equity Futures in India have a trading cycle of three months. You can take a position to trade in a share or index futures for the current month or the next two months. Currency futures are traded in cycles of 12 months.
Futures have a specific date on which they expire. This is called the expiry date. The futures contract must be settled on the expiry date. In India, the expiry date for futures is usually the last Thursday of the expiry month.
To trade in futures, you must deposit a minimum margin. This helps cover any losses that arise. Futures are usually traded using leverage.
Options contracts are similar to futures, in the sense that they are based on an underlying asset to be traded in future. However, unlike a futures contract where both the buyer and seller are obligated to fulfil their agreement, options provide the buyer with a choice.
For instance, a buyer can enter into an options contract with a seller to buy 100 shares of XYZ company at ₹12 per share. In return, she pays a premium of ₹50. If the share price goes to ₹15 on the expiry date, she will exercise her right to buy. If the share price falls to ₹10, she will let the options contract expire worthless. Note that while an options contract buyer can choose not to exercise their option, a seller must always fulfil the contract.
There are two kinds of options contracts - call options and put options. Call options give the right, not the obligation, to buy the asset. Put options give the right, but not the obligation, to sell the asset.
Let’s compare how you would trade in a futures contract versus an options contract. In futures, if you have a positive bias, that is, you expect the prices of the underlying to go up, you would go long or enter into a contract to buy the asset. If you have a negative bias, that is, you expect the price of the underlying to fall, you would go short or enter into a contract to sell the asset. In options, the strategy for a positive bias and a negative bias involve two separate instruments. If you expect the price of the underlying to increase, you would buy a call option on it. If you expect the price of the underlying to fall, you would buy a put option on it.
The terms you should know when it comes to options contracts are:
This is similar to futures. Options contracts also have a minimum lot size that they have to be traded on.
Contract value means the lot size multiplied by the options price. The options price is based on its intrinsic value and time to expiry. The intrinsic value is the difference between the current price of the underlying and its strike price.
Premium is the price that an options buyer must pay to enjoy the right, but not the obligation, to exercise their option. It compensates the seller for the risk that they assume.
The strike price is the price at which the options buyer can exercise their right to buy or sell. It remains fixed throughout the duration of the contract.
Futures vs. Options
Why choose Derivatives Trading?
- The primary reason to get into derivatives trading is to protect yourself from price risk. For instance, if you hold a certain number of shares, you can purchase a stock market derivative in the opposite direction to reduce your risk. Buying a put option can help you reduce your risk of a price fall in shares.
- You could also speculate in the market to make a profit. Speculation involves taking a position expecting a high return.
- Financial markets are imperfect. This means that the price of an asset could differ in two different markets. You could take advantage of this to make a profit. For example, if the price of a share is ₹100 in the spot market but ₹105 in the futures market, you could profit from it.
- Derivatives allow you to take on leverage to trade. Leverage means using money you don’t actually own to make returns. If you make the right bet, you can amplify your returns by many times through leverage.
What to be aware of while Trading Derivatives?
- Derivatives are based on the price of underlying assets that can fluctuate wildly. This makes them volatile instruments that can rake up huge losses if not traded prudently.
- Derivatives are often used for speculation. Baseless speculation opens up the potential for high losses.
- While leverage can amplify returns on a good bet, if the market moves in direction opposite to what you’re betting on, you could make a much higher loss than if you had traded without leverage.
How do Share Markets and Derivatives Markets Sync-up?
If you trade in stock market derivatives, the price movement of the derivative contract will be determined by the price of the underlying stock. The change in the underlying asset price will change the value of your derivative contract.
To understand this better, let’s look at the concept of delta. Delta is a risk metric that calculates how the value of a derivative will change with a ₹1 increase or decrease in the underlying. When you trade in stock market derivatives, say a NIFTY index derivative, a change in the NIFTY value will impact the value of your futures or options contract.
The delta of futures contracts is one. For instance, if NIFTY Spot moves from 18340 to 18350, then NIFTY Futures will also move from 18347 to 18357, assuming the NIFTY Futures trades at 18347 when the spot is at 18340.
On the other hand, options contracts do not have a delta equal to one due to the different variables that impact options. For instance, time is a crucial factor to determine the price of an options contract.
The delta for a call option will range from 0 to 1 because when the price of the NIFTY index increases, the call options price also increases. The delta for a put option ranges from -1 to 0 since the opposite occurs.
It is important for derivatives traders to keep an eye on the movement of NIFTY prices if they want to create a delta neutral strategy. A delta neutral trade evens out the response to market movements, thereby ensuring you do not rake up losses. If you want to hedge your index positions, you need a delta neutral strategy.
Prerequisites to Trade in the Indian Derivative Market
To trade in the Indian derivative market, you need three things:
- A Demat Account to store your electronic securities
- A Trading Account to conduct your trades
- Margin requirement, as specified in your derivative contract
Getting Started with Trading Derivatives in India
Derivatives trading is quite similar to trading in the cash segment of the stock market. Start by doing your research on the underlying asset. Since the prices deal with the future, you need to understand how the market will move. Based on your research, you can create a trading strategy.
When you are ready, you can place an order through your Trading Account. Make sure you have the margin requirement and that it fits your budget. Wait for the contract to expire to pocket your profit or note your loss. You can also take the help of a broker or assistant like Investmint to get trading signals. However, always understand the mechanism that is employed.
Taxes and Charges
Derivative contracts involve certain charges and taxes to execute. These include brokerage charges, stock exchange charges, Integrated Goods and Service Tax (IGST), Securities Transaction Tax (STT), stamp duty, etc. You need to be aware of these charges before you get into derivatives trading.
- Derivatives are financial instruments that derive their value from something else. This could be stocks, indices, commodities, currencies, exchange rates or interest rates.
- There are four types of derivatives - futures, options, forwards and swaps. Futures and options are the most commonly traded derivatives in India.
- Futures are standardised contracts in which two parties agree on the purchase and delivery of an asset. The prices are fixed in advance and the date of delivery is also pre-decided.
- Options are like futures. Only, instead of the right to buy or sell, it gives the options buyer the choice to buy or sell. The options seller must fulfil his/her obligation.
- Options are of two types - call options and put options. Call options give the buyer the right, not the obligation to buy the asset. Put options give the buyer the right, not the obligation to sell the asset.
- The primary reason to get into derivatives trading is to protect yourself from price risk. You could also choose to speculate or take advantage of arbitrage opportunities.
- However, when trading in derivatives, you should be careful of wild fluctuations, counterparty risk and the risk that comes with high leverage.
- To trade in derivatives in India, you must have a Demat Account, a Trading Account and the initial margin to participate.