What are the Different Types of Derivatives

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  • 28 Sep 2023

Derivatives are financial contracts that rely on an underlying asset or a group of assets for their value. These assets commonly include stocks, bonds, currencies, commodities, and market indices. The value of these underlying assets fluctuates in response to market conditions. The primary objective when entering into derivative contracts is to actively seek profits by speculating on the future value of the underlying asset. Here are the different types of derivatives you will find in stock markets.

The different types of financial derivatives are as follows:

  • Futures Contracts

Futures contracts refer to agreements to purchase or sell an underlying asset at a pre specific price on a future date. In Indian stock markets, futures contracts are widely used for commodities, currencies, and equity indices.

  • Options Contracts

Through options contracts, you have the right (but not obligation), to purchase (call option) or sell (put option) an underlying asset at a predetermined price within a predetermined time frame. They are used for hedging and speculative purposes.

  • Forward Contracts

These are agreements to purchase or sell an asset at a predetermined price in the future. These contracts are typically not standardized, making them more flexible but also riskier than futures contracts.

  • Swap Contracts

Swap contracts involve the exchange of cash flows or liabilities between two parties. Common types of swaps in India include interest rate swaps and currency swaps, which help manage interest rate and currency risk.

  • Commodity Derivatives

Commodity derivatives allow investors to trade in various commodities like gold, silver, oil, and agricultural products. These derivatives help stakeholders manage price volatility associated with commodities.

  • Equity Derivatives

Equity derivatives are linked to stocks and equity indices. This category includes equity futures and options, enabling investors to hedge or speculate against price movements in individual stocks or indices.

To engage in the derivative market:

  • You must initiate trading by depositing a margin amount. It is essential to note that this margin amount remains inaccessible until the trade concludes. Furthermore, it becomes necessary to replenish this amount when it dips below the stipulated minimum level.

  • Active participation in derivative trading mandates the possession of an operational trading account. This account should grant you the privilege to engage in derivative trading activities. If you opt for a brokerage service, you can conveniently place orders either online or through a telephonic transaction.

  • When selecting stocks for derivative trading, many factors should guide your decision-making process. Factors to consider encompass your available cash reserves, the margin prerequisites, the contract price, and the current value of the underlying shares. It is imperative that these elements align with your predetermined budget.

  • You can decide whether to remain invested until the contract's expiry date for trade settlement. In this scenario, you face two options: either clear the entire outstanding amount or enter into an opposing trade to offset the current position.

  • Engaging in derivative contracts serves a dual purpose. You can enter into such contracts with the intent of reaping profits by accurately predicting market movements. Alternatively, you can employ derivatives as a protective measure to shield yourself from potential losses in the spot market where the stock is actively traded.

Derivatives play a vital role in the Indian financial markets for several reasons:

  • Risk Management: Investors and businesses use derivatives to hedge against price fluctuations, reducing the impact of market volatility on their portfolios and operations.

  • Speculation: Traders use derivatives to speculate on price movements, potentially earning profits through leverage and market analysis.

  • Liquidity: Derivatives enhance market liquidity by allowing participants to trade in large quantities without directly owning the underlying assets.

  • Price Discovery: The derivatives market often leads to better price discovery, as it reflects market participants' collective expectations and sentiments.

Summing it Up

Understanding the different types of derivatives is essential for anyone involved in the Indian stock markets. These financial instruments, such as futures, options, forward contracts, swaps, and commodity and equity derivatives, provide various opportunities for risk management, speculation, and portfolio diversification.

Whether you are an investor, trader, or business owner, incorporating derivatives into your financial strategy can be a valuable asset in navigating the dynamic landscape of Indian financial markets.

FAQs on Different Types of Derivatives

Derivatives get their value from an underlying asset or a collection of assets in financial contracts. The various types of derivatives are futures contracts, forward contracts, options contracts, equity derivatives, etc.

Derivatives come with significant drawbacks, including exposure to counterparty risk, the inherent perils associated with leverage, and the potential for complex networks of derivative contracts to contribute to systemic risks.

Investors commonly employ derivatives for three primary purposes: hedging positions to safeguard against asset risks, harnessing high leverage for potential gains, and speculating on the movements of assets. Hedging serves as a protective measure against asset-related risks.

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