Understand Derivatives in Financial Market
A derivative market is the market where trades in financial instruments like futures and options take place. Financial instruments like futures and options derive their values from the underlying asset. We know derivative instruments are used by traders to generate income by trading, but the actual purpose behind derivative instruments in financial market is for portfolio hedging. Derivative instruments are also used for speculating and arbitrage trading in financial markets.
Trading in derivative markets involves considerable risk and high reward. So, traders must acquire proper market knowledge and risk management skills before entering the world of derivative market. The most common way of trading in derivative market is speculation. Traders generate an income by speculating about the derivative instrument of an asset. Traders take long positions and short positions anticipating the premium price of derivative instrument to move accordingly. Let us understand in detail the basics of the derivatives market.
Types of Derivatives Traded In Stock Market
Futures contract
A future contract is the agreement between a buyer and seller to make a trade at an agreed price on a future date. Futures contracts are used by traders for hedging purposes and speculation. Investors protect their investment portfolio from a crash or volatility by using the future contract as a hedging instrument. Short sellers can use stock futures to create a positional short position in stocks.
Let us understand the Future contracts in detail with an example of a wheat farmer and a businessman. The wheat farmer has some wheat ready for cultivation next month and the current price of wheat is 50/Kg. The wheat farmer is happy to sell his wheat at a price of 50 but his wheat will be ready for sale next month only. In this case wheat farmers are afraid about whether the price of the wheat will move down. To prevent the downward risk the wheat farmer can enter into a futures contract. In other hand there is a businessmen who anticipates the wheat price to move up. In this scenario the wheat farmer and businessmen can enter a future contract agreeing to purchase the wheat at a price of 50 /Kg next month.
By entering into the futures contract the wheat farmer can sell his wheat at a price of 50 next month, avoiding the downside risk. If the price of wheat moves up next month according to the analysis of businessmen, he can buy at a lower price of 50 from farmer and can make profit by selling at a higher price in market.
Lot Size and Capital Required for Different Future Contracts
| Future Contracts | CMP (Current Market Price) | Lot Size | Capital Required (Estimate) | Tick Size |
| Nifty | 18,231 | 50 | 1,03,331 | 0.05 |
| Bank Nifty | 43990.1 | 25 | 1,46,730 | 0.05 |
| Midcap Nifty | 7482 | 75 | 73,094 | 0.05 |
| Nifty Financial services | 19438.05 | 40 | 93,552 | 0.05 |
In case of stocks , different stocks have different lot sizes. Lot size of a stock depends on the liquidity of a stock , market capitalization and volume. Lets take an example of Tata motors with current market price of 524.70 as on May 21st 2023.
Lot size of Tata Motors is 1425 and capital required is 1,69,814.Rs
Option contracts
The buyer of an options contract has the option, but not the obligation, to purchase or sell an asset at a defined price on or before an agreed-upon future date.. Let us put the word Option in front for better understanding, in an option contract there is an actual option for the buyer to decide whether he wants to buy the asset or not at a predetermined price within a specified time. In the case of an option buyer, it is not mandatory to exercise the transaction on a fixed date with the seller. Option Buyer must pay a premium for entering an option contract. The premium paid is the maximum loss for the option buyer.
For an option seller, the seller has the obligation to sell an asset at the pre-determined price at the fixed date. Option seller has no option to sell an asset and must execute the transaction at the fixed time. Option sellers have unlimited risk and option buyers have a risk of their premium paid.
Example
Let us understand with the example of a Real estate owner and a buyer to learn option contracts in detail. consider the real estate owner as the option seller and buyer as an option buyer. Here the buyer is interested in buying the real estate and decides to enter into an option contract with the real estate seller. They both entered a contract agreeing to buy the property for 50 lakh after six months. The buyer pays a premium of 10,000 Rs and enters a contract with Real estate seller, that he will buy within a time of 6 months.
Here the Real estate buyer has no obligation to buy the property from the real estate seller after six months. If the demand for the property goes down, the buyer will stay away from buying the property. Buyers’ maximum loss will be the premium paid amount of 10,000 Rs.
But the real estate seller being the option seller has the obligation to sell the property after six months at a fixed price at the time of entering the contract. In the case of an option seller, even though the demand for the property has increased than their fixed price, the seller has an obligation to sell the property at the fixed price.
In conclusion, an option buyer enters a contract anticipating the price of the underlying asset to move up to make a profit in the market. Option sellers enter a contract expecting the price of the underlying asset to move down to make profit in the market.
Two types of Option contracts
call options contract
- A trader can enter a Buy call option contract if he is bullish on the underlying asset.
- A trader can enter a sell call option contract if he is bearish on the underlying asset.
put options contract
- Trader can enter a Buy put option contract if he is bearish on the underlying asset.
- A trader can enter a sell put option contract if he is bullish on the underlying asset.
Lot Size and Capital Required for Different Option Contracts
| Option Contracts | CMP (Current Market Price) | Lot Size |
| Nifty | 18,231 | 50 |
| Bank Nifty | 43990.1 | 25 |
| Midcap Nifty | 7482 | 75 |
| Nifty Financial services | 19438.05 | 40 |
In case of stock options different stocks have different lot sizes. Capital required for every option contract varies according to the selected strike prices.
Forward contract
It is a type of derivative instrument used in financial markets. A forward contract traded on the stock market is an agreement between two participants to buy or sell a stock or any other underlying asset at a predetermined price on a future date. Unlike futures contracts, forward contracts are not traded on exchanges, they are typically traded over the counter (OTC).
In a forward contract, both participants are obligated to keep the terms of the agreement on the predetermined future date. The buyer has the obligation to buy, and the seller has an obligation to sell the underlying asset at the price agreed in the contract. Forward contracts are mainly used by businesses to hedge their risk against price fluctuations in the stock market. forward contract is a prominent risk management tool used by businesses.
Swaps
Swaps are derivative contracts used in the stock market to manage and hedge risks. It is a contract between two parties to swap cash flows or liabilities over a certain period. They are used to manage interest rate risks, currency exposure, and fluctuating commodity prices. Different types of swaps traded in stock market are
- Interest Rate Swaps
- Equity Swaps
- Commodity swaps
- Currency Swaps
