Derivatives

Just as shares are bought and sold in the stock market, derivative instruments are also traded in the market. Widely considered as one of the most complex financial instruments, here is a basic introduction to them

1. What are derivatives?

Derivatives are an agreement to buy or sell the underlying shares in the future. These agree ments are sold in the market and are referred to as `contracts.' They are available for shares, indices, currencies and commodities. Therefore, their value is derived from that of the underly ing asset. Hence, the term `Derivatives'.

2. What are the different types of derivatives?

Futures and Options (F&O) are the two most popular derivatives.

Futures are contracts between two parties to either buy or sell a particular number of assets at a particular time in the future for a fixed price. An Option is a similar contract, but the only difference is that the parties are not obli gated to fulfill the terms of the agreement.

3. What are the advantages of trading in derivatives?

There are three main reasons why investors look at trading in derivatives -arbitrage, hedging and margin trade. Arbitrage is when stock traders look at enhancing their profits. Since an investor is essentially betting on the future for an increase or decline in stock prices when it comes to futures, this provides a good way to increase profits. Hedging is the most common use of derivatives trading. This means an investor buys in the cash segment and agrees to sell in the derivatives market or vice versa. Thus, shielding from potential losses.

4. Why are traders drawn to derivatives?

This is because traders can bet on stocks, indices, currency , in terest rates by paying only a smaller amount upfront. An investor only pays a margin to buy futures. This is because the actual value of the contracts would be too large (in lakhs and crores). However, when the investor makes a profit, the percentage of growth is exponentially higher which allows himher to make more money .

5. How can an investor start trading in derivatives?

F&O contracts in both index as well as stocks can be bought and sold through the trading members of the NSE. Some trading members also provide Internet to trade in the F&O market. An investor has to open an account with one of the trading members and complete the related formalities which include signing of memberconstituent agreement, KYC form and risk disclosure document. The trading member then allots the investor a unique client identification number. In order to begin trading, the investor must deposit cash and or other collaterals with their trading member.