Understanding the share market can be confusing, especially when it comes to derivatives. In simple terms, derivatives are financial contracts whose value is linked to an underlying asset, like stocks, commodities, or indices. They play an important role in the financial markets, providing opportunities for risk management and speculative gains.
Derivatives in the Share Market
In the share market, derivatives are special financial contracts. Their value depends on an underlying asset, like stocks, commodities, or indices.
There are several types of derivatives, such as futures and options. A future is a contract that obligates you to buy or sell an asset at fixed price on a future date. An option, however, gives you the right—but not the obligation—to buy or sell an asset at a specified price before a certain date.
Investors use derivatives to mitigate risk or to profit by forecasting price movements. Although derivatives can be complex, they are essential in financial markets, aiding in price discovery and risk management.
How do Derivates Work in the Share Market?
Derivative trading in the share market involves buying and selling contracts based on the value of an underlying asset, like stocks, commodities, or indices.
Instead of trading the actual asset, you’re trading a contract that gets its value from the asset’s price. Derivative contracts come in two main types: futures and options.
A futures contract involves a commitment to buy or sell an asset at a fixed price on a future date. For instance, you might commit to purchasing 100 shares of a company at $50 each within three months.
Options trading, on the other hand, provides you with the right, but not the obligation, to buy or sell an asset at a designated price before a specified date. This flexibility allows you to opt out of the trade if it doesn’t suit your interests.
Key Players Involved in Derivative Trading:
- Hedgers: These are investors who use derivatives to reduce risk. For example, a farmer might use futures contracts to lock in the price of their crops.
- Speculators: These traders try to profit from price movements. They buy derivatives, hoping the value will rise or fall in their favour.
- Arbitrageurs: These investors try to profit from price differences in different markets. They buy derivatives in one market and sell them in another where the price is higher.
- Margin Traders: These traders use borrowed funds to trade derivatives, aiming for higher returns but taking on more risk.
Types of Derivatives
Derivatives are mainly of three types:
Futures
- Futures are contracts where you agree to buy or sell an asset at a specific price on a future date. It’s like making a deal today to buy something in the future.
- For example, you might agree to buy 100 shares of a company at $50 each in three months.
- This helps investors lock in prices and manage risks. If the price goes up, you benefit from the lower agreed price. If it goes down, you still have to buy at a higher price.
Options
- Options give the right, but not the obligation, to buy or sell a predetermined price before a certain date.
- There are two types: call options and put options. A call option gives you the right to buy an asset, while a put option gives you the right to sell it.
- You can use the option to buy or sell at a better price, if the market moves in your favour. If it doesn’t, you can opt not to use the option.
Swaps and Forwards
- Swaps and forwards are more complex derivatives. A swap is a deal where two parties exchange cash flows or financial assets with each other.
- For example, one party might agree to pay a fixed interest rate while receiving a variable rate from the other party. This is often used to manage interest rate risks.
- Forwards are similar to futures but are not traded on an exchange. They are private deals to buy or sell an asset at a price on a future date. Because they are private, they can be customised to meet the needs of both parties.
What is Commodity Derivatives Market?
The commodity derivatives market is a place where people trade contracts based on the price of physical goods like gold, oil, or agricultural products.
Instead of buying the actual commodities, traders buy and sell contracts that represent these goods.
Other examples include oil futures, where you agree on the price of oil, and agricultural futures, like those for wheat or corn.
The commodity derivatives market is crucial in helping producers and consumers manage price risks.
For instance, a farmer can use futures contracts to lock in the price of their crops, ensuring they get a stable income regardless of market fluctuations. Similarly, an airline might use oil futures to lock in fuel prices, protecting against sudden spikes.
This market also helps in price discovery, which means it helps determine the fair price of commodities based on supply and demand.
Advantages of Derivatives in Share Market
| Advantage | Description |
| Risk Management | Protects against price changes. |
| Leverage | Control large positions with less money. |
| Price Discovery | Helps find fair market prices. |
| Flexibility | Can be tailored to specific needs. |
| Lower Costs | Often cheaper to trade than the actual asset. |
Conclusion
Derivatives are a significant part of the share market, offering tools for managing risk and making informed investment decisions. By understanding the different types of derivatives, how they work, and their advantages, you can better navigate the financial markets.
Whether you’re a new investor or looking to expand your trading strategies, knowing about derivatives can enhance your financial knowledge and confidence.
FAQs
Ans: A stock signifies ownership in a company, whereas a derivative is a contract whose value depends on the price of an asset, such as a stock.
Ans: A commodity derivatives market is where contracts based on physical goods like gold, oil, or agricultural products are traded, helping manage price risks.
Ans: Yes, derivatives can be risky due to their complexity and potential for significant losses if the market moves against the investor’s position.
Ans: Derivatives in the share market are contracts based on stock prices. For example, a stock option gives you the right to buy or sell a stock at a set price before a specific date.
Ans: The key players include hedgers, who manage risks; speculators, who seek profits; arbitrageurs, who exploit price differences; and margin traders, who use borrowed funds.
