Many of us invest our hard-earned money in the stock market by taking risks and thinking of making good returns. But a lot of us don’t know that investing in the stock market can turn out to be risky due to price fluctuations of securities like currency, commodities, equity, etc.

During these times, anyone may end up losing all their money, and this can wipe out their entire investments within a fraction of seconds. However, several instruments can protect you from the volatility of financial markets.

These instruments not only protect traders from risk but also deliver guarantees to them. These instruments are none other than derivatives.

With the help of this article, let’s understand what derivatives are and who can participate in the derivatives market.

What is a Derivative?

Financial contracts that get their value from a group of assets or underlying assets are called derivatives. Based on the market conditions, the value of the derivatives keeps on changing.

The prime motive behind entering into derivative contracts is to make a large chunk of profits by contemplating the underlying asset’s value in the future.

Let’s assume that you have invested in an equity share, and that particular share is quite volatile. Moreover, you may suffer a loss if the market falls due to a stock value downfall. In this case, you may enter into derivative trading through a derivative contract, either to make a profit by placing a bet on the exact value or just to rest from the losses you have faced in the stock market where the stock is being traded.

Who are the Participants in the Derivatives Market?

Participants in the derivatives market can be classified into 4 categories based on their trading motives.

Speculators:

Speculators bear the risk in the market. They embrace risk to earn a profit. They have an opposite point of view as compared to the hedgers. This opinion difference helps them make huge profits if the bets turn correct. Let’s say that you bought a put option to secure yourself from a fall in stock prices. Your counterparty, i.e. the speculator, will have to bet that the stock price won’t fall. If it is so, then you won’t exercise your put option. Therefore, the speculator keeps the premium and makes a profit.

Hedger:

Hedgers are risk-averse traders in the stock markets. They aim at derivative markets to secure their investment portfolio against market risk and price fluctuations. They do this by assuming the exact opposite position in the derivatives market. In this manner, they transfer the risk to those ready to take it. However, they have to pay a premium to the risk-taker for the hedging available.

Let’s understand with an example.

Suppose you hold 100 shares of a company ABC, which are currently priced at Rs 120, and you aim to sell these shares post 3 months, but you don’t want to incur losses during these 3 months due to the fall in the market price. Also, you don’t want to lose the opportunity to make profits by selling them at a higher price in the future. In this case, you can buy a put option by paying a nominal premium that takes care of both the above conditions.

Margin Traders:

Margin means the minimum amount you need to deposit with the broker to participate in the derivative market. It is used to reflect losses and gains daily based on the market movements. It gives leverage in the derivative market and maintains a large outstanding position.

Arbitrageurs:

These use the low-risk market imperfections to gain profits. They usually buy low-priced securities simultaneously in one market and sell them at a higher price in another market. However, this can only happen when the same security is quoted at different prices in different markets.

What are the Different Types of Derivative Contracts in India?

There are primarily four types of derivative trading in India: forwards, futures, swaps, and options.

Forwards:

These are just like futures contracts, but in this, the holders are under the obligation to perform the contract. However, forwards are unstandardized and not traded on the exchanges. These are available over the counter and are not marked market-to-market. Moreover, these can be customized to suit the parties’ requirements of the contract.

Futures:

These are standardized contracts allowing the holder to buy or sell the asset at an agreed price at the specified date. The parties under the future contract are under the obligation to perform the contract. Moreover, these contracts are traded on the stock exchange, and the value of the contracts is marked on the market every day.

Swaps:

In a swaps contract, two parties exchange their financial obligations. The cash flows depend on the notional principal amount agreed by both parties without the exchange of principal. This amount of cash flow is based on a rate of interest. One cash flow is fixed, but the other keeps changing based on the benchmark interest rate. Interest swaps are the most commonly used category and are not traded on stock exchanges.

Options:

These derivative contracts allow buyers to buy/sell the underlying assets at the specified price. However, the buyer is under no obligation to exercise the option. The option seller is known as the option writer, and the specified price is the strike price.

Derivative contracts like forward, futures, options, and swaps are the best options to earn profits. The traders can analyze and predict the future price movement of their equity shares and accumulate huge profits out of these contracts.

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