There is a buzz in the market that a new smartphone with features you have never heard of is about to launch in India. The company has set a pre-launch price of the phone at Rs 1 lakh. However, it is also expected that a few days after the launch, the smartphone’s price will see a major hike. With Rs 50,000 in your pocket, to protect yourself against the price hike, you visit the smartphone dealer. You pay him Rs 50,000 in advance and request him to sell you the smartphone after its launch at today’s price. This way, you lock in the price without paying the entire amount upfront. This is essentially what derivatives are about.
What are Derivatives?
Derivatives are financial agreements that get their value from other assets like commodities, shares, or bonds. They help traders like you to manage risks, speculate on price changes, and reach markets that might be hard to enter. The most common types are futures, options, and forwards. Derivative trading allows you to navigate these instruments effectively, Using a Demat App can simplify the process of managing derivative contracts and tracking market movements efficiently. You can also find swaps derivative contracts on the market that mitigate the fluctuation risk of interest rates and currencies.
What are the Different Types of Derivatives?
Let’s consider gold as an example to understand different types of market derivatives and how they work. Gold derivatives allow you to speculate on gold’s future price without owning the physical metal. You can do this through various instruments:
- Gold Futures: They are standardised agreements executed on exchanges. Here, you consent to buy or sell a specified quantity of gold at an agreed price on a future date. This method allows you to guard against price variations or bet on future price developments.
- Gold Options: These provide you with the option, without the obligation, to purchase or sell gold at a predetermined price before a specified date. Options can serve as a way to protect against potential losses or to speculate on price fluctuations with reduced risk.
- Gold Forwards: These agreements are similar to futures contracts yet are traded OTC and can be adjusted to suit the needs of the parties. Firms typically employ forwards to mitigate risks associated with future gold price changes.
What are Swaps in Derivatives?
Swaps are contracts where two parties agree to exchange cash flows or other financial assets over a specified period. You can think of swaps as a financial agreement where one party trades the benefits of one asset for another. For example, in an interest rate swap, one party might exchange a fixed interest rate payment for a variable interest rate payment with another party. This can help manage exposure to fluctuations in interest rates.
Here’s an example for a better explanation.
Suppose Company A has a loan with a fluctuating interest rate, and Company B has a constant interest rate. They agree to exchange their interest payments. Company A will pay Company B’s fixed rate, and Company B will pay Company A’s variable rate. This gives Company A predictability of fixed payments, while Company B might benefit if the variable rate falls.
Advantages of Derivatives
- Derivatives trading plays a crucial role in hedging risk. By entering into a derivative contract, you can shield yourself from the price volatility of the underlying asset. For example, an airline might utilise futures contracts to secure fuel prices, thus reducing the impact of rising fuel expenses.
- One significant advantage of equity derivatives is the ability to control a large position with a smaller investment, a concept known as leverage.
- Derivatives enhance market efficiency by facilitating price discovery. They reflect the market’s predictions regarding future prices, establishing current prices for underlying assets.
- Through derivatives, investors can gain exposure to markets or assets that may not be readily available. For instance, an investor in India can utilise currency derivative swaps to access foreign currencies without having to trade directly in the forex market.
- Engaging in derivative trading typically incurs lower transaction costs than trading the underlying assets, making it particularly advantageous for substantial transactions.
- Derivatives also provide avenues for speculation, allowing traders to make predictions about future market movements. For instance, a trader might use options to speculate on whether a stock’s price will rise or fall without needing to own the stock itself.
- Derivative contracts can be customised to suit specific requirements, such as adjusting the expiration date or strike price in options.
- By facilitating risk transfer, derivatives can contribute to price stability. For example, farmers may use futures contracts to secure their crops’ prices, which helps reduce volatility in agricultural markets.
- The share market derivatives typically offer high liquidity, simplifying the process of entering and exiting positions. This liquidity can be especially beneficial during market turbulence.
Mistakes to Avoid When Trading Derivatives in Stock Market
Lack of Proper Research:
Jumping into derivatives trading without thorough research is a recipe for disaster. For example, suppose you decide to trade gold futures without understanding the factors that influence gold prices, such as geopolitical issues or shifts in interest rates. In that case, you might end up making uninformed decisions.
Ignoring Risk Management:
Proper risk management is key to derivatives trading. This includes setting stop-loss orders to control potential losses. For example, if you buy gold futures, choose a stop-loss price that fits your loss tolerance. Not doing this can lead to a wipe-out of your entire capital.
Overleveraging:
While leverage can amplify profits, it can intensify losses. Traders often misjudge their leverage, leading to major financial repercussions. For instance, if you use 10:1 leverage and the market declines by 10%, you might lose your investment.
Lack of Market Knowledge:
A deep awareness of market conditions is essential for trading derivatives successfully. Without this insight, you may misread crucial market signals. For example, entering options trades without understanding the Greeks (Delta, Gamma, Theta, and Vega) can lead to poor choices and potential losses.
Emotional Trading:
Making trading choices based on emotions is a common pitfall. Fear and greed can blur your judgment. If you react in panic during a market drop, you risk missing a potential recovery.
Ignoring Economic Indicators
Economic indicators can significantly affect the derivatives market. Ignoring these can lead to unexpected losses. For example, if you are trading currency futures and ignore an upcoming interest rate announcement, you might be caught off guard by sudden market movements.
Strategies for Derivatives Trading
Some of the key strategies for derivatives trading are:
Arbitrage
Arbitrage means profiting from price differences across various markets. If a stock is available for less on one exchange compared to another, you can purchase it at a lower price and sell it at a higher price. This approach requires prompt execution and low transaction fees to be effective.
Spread Trading
Spread trading means taking opposing positions in two related futures contracts. For example, if you believe the wheat price will outpace corn, you could buy a wheat futures contract and sell a corn futures contract. This method helps manage risk by concentrating on the price difference between the two contracts.
Straddle Strategy
In a straddle, you buy a call and a put option on the same asset, targeting the same strike price and expiration. This method is effective when you predict significant volatility but can’t determine if the price will rise or fall.
Consider a stock trading at Rs 200. You buy a call and a put option at this strike price. If the stock price changes dramatically in one direction, you stand to gain from the fluctuation.
Butterfly Spread
A butterfly spread is a neutral strategy requiring purchasing and selling multiple options at different strike prices. For example, you could buy one call option at Rs 100, sell two call options at Rs 110, and acquire another call option at Rs 120. This strategy aims to profit in a low-volatility environment.
Iron Condor
The iron condor means selling a put option at a lower strike and a call option at a higher strike while simultaneously buying a put option at an even lower strike and a call option at an even higher strike through a derivatives app. This method is ideal for situations with expected low volatility, as it allows traders to collect premiums from the options sold. For illustration, if a stock trades at Rs 100, you might sell a put at Rs 90 and a call at Rs 110 while buying a put at Rs 80 and a call at Rs 120.
Conclusion
Derivatives trading offers various advantages, including risk management, leverage, and market access. However, it is essential to approach trading with proper research, risk management, and a clear strategy to avoid common pitfalls. With the right knowledge and techniques, derivatives can be a great tool for hedging and speculating in the financial markets.
To begin trading in derivatives, first proceed with a Demat account opening online with a reputed broker like HDFC SKY.
