What is Derivative Trading? Types, Examples, Pros & Cons Explained

In the stock market, many times people do not buy stocks directly, but bet on their prices using derivative financial contracts. Today, the use of derivatives in the stock market is not just limited to institutional traders; retail traders are also actively using them. They were created to protect the portfolio from risk, but now they have also become a means of earning speculative profits. 

In this blog, we will learn about types of derivatives, how to use them correctly, what are the advantages and disadvantages of derivatives market, and the things to be kept in mind while trading them.

What is Derivative Trading?

Derivative trading is a process in which you speculate or try to profit from the predicted future price movements of an asset by using related derivative contracts, rather than buying or selling it directly. In simple terms, a derivative is a class of financial instruments whose price is based on another asset (which we call “underlying asset”). This asset can be anything – shares, index, currency, commodity or interest rate.

To understand derivatives trading better, let’s look at an example. Suppose a trader expects a poor monsoon this year and expects a shortage of crops and a rise in prices. To benefit from this expected price increase from future crop shortage, he buys a futures contract with the crop as an underlying asset on the exchange. If the price of the crop does rise as he predicted, he can sell the futures contract at a higher price and earn a profit.

Similarly, investors in the stock market trade derivatives contracts, which either gives their portfolio security from adverse price movement or an opportunity to earn profit from future price movements. In physical trading, you directly buy assets such as shares of a company, but in derivative trading you only bet on the direction of the price of the underlying asset and try to earn profits.

There are three main types of participants in the derivatives market :

• Hedgers, who trade to protect their investments from unnecessary risks
• Speculators, who trade to earn profits
• Arbitrageurs, who take advantage of price differences in different markets

Today, derivatives have become very popular not only among institutional investors but also among ordinary retail traders.

Read Also: Index Derivatives in India

Types of Derivatives Trading

Different types of derivatives are listed below:

1. Futures Contracts

Futures are a standardized agreement in which the buyer and seller make a deal to buy and sell an asset respectively at a fixed price on a fixed future date. These contracts are traded on exchanges.

Example: If someone thinks that the price of gold will rise, he can buy Gold Futures and later sell it at the increased price and make a profit. Futures are used by institutional as well as retail investors and traders for both hedging and speculation.

2. Options Contracts

In options derivatives, the buyer has the right to buy or sell an asset, but there is no obligation. There are two types of these – Call Option (right to buy) and Put Option (right to sell).

Example: Suppose an investor fears that his stock may fall in price, then he can protect himself by buying a Put option. Options are popular especially among retail traders because when buying options, the risk is limited to the premium paid, while the potential return can be very high.

3. Forward Contracts

Forwards are also like futures, but a big difference is that they are not traded on the exchange but are available OTC (Over the Counter) i.e. privately between two parties. They are more flexible because they can be customized according to the needs of the parties.

Example: Companies often use forwards to protect against adverse price fluctuations in foreign currency or raw material prices.

4. Swaps Contracts

Swaps are customized agreements between two parties to exchange future cash flows based on specified financial instruments, such as interest rates or currencies. In a swap, each party agrees to pay the other cash flows that are calculated in different ways. Swaps are generally traded over-the-counter (OTC), making them less accessible to retail investors.

Example: A multinational company based in the U.S. earns most of its revenue in euros but has to pay its expenses in U.S. dollars. To reduce the risk of euro-to-dollar exchange rate fluctuations, it enters into a currency swap with a bank. In this agreement, the company agrees to exchange euros for dollars at a fixed rate at specific future dates. This helps the company lock in exchange rates and better manage its cash flows.

Read Also: What Is Day Trading and How to Start With It?

Comparative Description of Types of Derivatives Trading

Type of Derivative	Where it is Traded	Obligation	Primary Use
Futures	Exchange	Yes	Hedging, Speculation
Options	Exchange	Buyer: No; Seller: Yes	Hedging, Directional Trading
Forwards	OTC	Yes	Currency & Commodity Hedging
Swaps	OTC	Yes	Interest Rate, Currency Exchange

How the Derivatives Market Works in India? 

India’s derivatives market operates under an organized and strictly regulated system, which is controlled by SEBI (Securities and Exchange Board of India). Derivatives are traded mainly on exchanges like NSE (National Stock Exchange) and BSE (Bombay Stock Exchange), in which Futures and Options are the most prominent segments.

• Futures and Options Segment : This segment deals with transactions of Futures and Options contracts based on indices (such as Nifty 50) and stocks. Every contract has a fixed lot size and an expiry date.

• Margin and Risk Control : To trade in certain derivative contracts such as futures, one has to deposit a certain margin, not the full contract amount. Mark-to-Market (MTM) settlement takes place after every trading day, in which the profit or loss of that day is adjusted on the next working day (T+1). 

• Role of Clearing Corporations : Clearing houses and other institutions play an important role in ensuring settlement of derivative instruments. They guarantee every trade and act as a counterparty between the two parties.

Advantages of Derivative Trading

The advantages of derivative trading are listed below:

• Risk Hedging : The biggest advantage of trading derivatives is that you can use them to protect your portfolio from market declines. For example, if you fear a decline in price of a particular stock you hold, you can limit your losses by buying a Put option.
• Leverage Advantage : Certain derivative instruments can be traded by paying only a small margin instead of the entire contract value. This gives you an opportunity to create a large position even with limited capital, which can significantly increase profits with the right trading strategy.
• Earning even in a falling market (Short Selling Opportunity) : Derivatives give you a chance to earn even in a downtrend. With the help of futures or put options, you can make profits even when the market falls.
• Better liquidity and exit facility : Derivatives on indices such as Nifty and Bank Nifty have heavy volumes daily, which allows easy entry or exit at any time.

Disadvantages & Risks of Derivative Trading

The disadvantages and risks of derivative trading are:

• High risks : Due to leverage in derivatives, the losses can be huge. If the market moves in the wrong direction even a little, you can lose your entire capital.
• Loss due to lack of knowledge : The complexity of options and futures contracts can confuse new investors. Wrong decisions can lead to significant losses if there is no proper understanding of concepts like strike price, expiry, premium, etc.
• Decreasing value with time (Time Decay) : Time can be the biggest enemy for option buyers. If the expected price move does not happen quickly, then the option can decline in value even with the passage of time.
• Emotional pressure and stress : The fast movement of the market and uncertainty sometimes leads to wrong trades out of fear or greed. This psychological stress can make trading in derivatives more dangerous.

Who should do Derivative Trading?

Derivative trading is suitable for the following:

• Experienced traders : Trading in derivatives is fast-paced and risky. In such a situation, it is most suitable for those who already have trading experience and understand charts, patterns or market cycles.
• Portfolio managers and hedgers : For those who want to protect their long term investments from market decline, derivatives can be an excellent means of hedging.
• Informed retail investors : If you are a retail investor but have an understanding of the market, know how to control risk, and trade with discipline, then you can also gradually step into derivatives.

Derivatives in Stock Market vs Other Asset Classes

Asset Class	Derivative Instruments	Ideal For	Exchange / Platform
Equity	Stock Futures, Stock Options (e.g., Reliance, HDFC)	Retail & active investors	NSE, BSE
Index Derivatives	Futures and options of Nifty 50, Bank Nifty, Sensex, etc.	Experienced traders	NSE, BSE
Commodities	Futures and options of Gold, Silver, Crude Oil, etc.	Professional traders, hedgers	MCX, NCDEX

Read Also: Trading For Beginners: 5 Things Every Trader Should Know

Conclusion

Derivatives are fast-paced, risky but strategic financial tools that can help protect a portfolio or earn huge profits if used with the right knowledge and discipline. It is not only useful for hedging but also opens the way for creating much larger positions with less capital. However, the complexity and the risks associated with these contracts cannot be ignored. If you want to trade in derivatives, it’s essential to first prepare yourself thoroughly: learn the concepts, understand the risks, and practice carefully before you start. Entering the derivatives market without proper knowledge and strategy can be risky and may lead to significant losses instead of gains. So, start wisely and always trade with caution.

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