What is Derivative Trading in the Share Market?

Derivative trading in the share market involves sophisticated financial instruments whose values are derived from an underlying asset, typically stocks. These instruments include options and futures, providing investors with opportunities to hedge risk, speculate on market movements, and diversify their investment portfolios. Derivatives play a crucial role in the share market by allowing participants to manage exposure to price fluctuations, leverage positions, and engage in strategic trading manoeuvres. Understanding the dynamics of derivative trading is essential for investors seeking to navigate the complexities of the share market and optimise their investment strategies.

Defining Derivatives

Derivatives are contracts that hold underlying assets with a volatile value. These underlying assets can be commodities, stocks, indices, currencies, or bonds. Traders can make a profit by looking at or trading these contracts in the derivative market. There are various types of contracts that are used for different purposes of trading.

Forwards

A forward contract is an over-the-counter contract or an agreement between parties to exchange instruments at a predetermined price on a given date. It works as an over-the-counter contract., and due to that, a forward contract does not have a central exchange for its operations. This contract is highly illiquid and does not require collateral; therefore, the risk for both parties is high.

Futures

In the future contract, trades are held in stock exchanges such as BSE and NSE. In future contracts, both parties must bind to a legal document that states the buying or selling of financial instruments at a predetermined price and expiry date.

Options

Just like futures, options allow traders to buy or sell financial assets at a specific price on a specified date. However, in the case of options, the buyer can decide whether or not they want to transact the underlying assets. You can trade options contracts on the BSE and NSE stock exchanges. To buy an option contract, you need to pay some amount which is known as the premium of the option contract. There are two options: a call option and a put option.

• Call Options: The buyer of the option gets the right to buy an asset from the seller at a fixed price.
• Put Options: In the put option, the buyer of the option gets the right to sell the financial asset of the option at a given price.

Prerequisites for Trading Derivatives

The prerequisites for trading in the derivative market are:

• You need to select a broker and create an online trading account that comes with a Demat account. Traders such as Share India offer free Demat and trading account opening. Once you open a Demat account, you can request to activate the F&O (futures and options) trading service.
• After activating the service, you need to pay a margin amount. This cash amount is upfront money that will be required to maintain until you execute or leave the contract. Remember, if the account falls below the minimum required margin, you will get a margin call to rebalance the trading account.
• After maintaining a margin amount, you can only trade in financial contracts which are available in the stock market. The broker platform lets you trade and show all the available contracts, which can take up to three months, with the expiry on the last Thursday of the month. To avoid auto-settling, you need to settle the contract before the specified expiry date.

Types of Traders In Derivative Trading

You can find four types of traders in the derivative market.

• Speculators: A type of trader that predicts the future change in the price of an underlying asset. According to their prediction, they can make a short or long derivative contract.
• Hedgers: A hedger invests in the derivative market to eliminate risks that are associated with the future price of other financial assets.
• Margin Traders: Traders are required to pay an initial margin amount to establish a particular position in the market. The margin, provided by the broker, is a percentage of the total value of the investor’s position. Utilising this margin, traders enhance their investment capacity, aiming for improved returns.
• Arbitrageurs: An arbitrageurs trader follows a trading method which is to exploit the price difference in two markets with the same financial asset. For example, a trader can take advantage of ABC securities that are priced at ₹100 on a stock exchange, and in other stock exchanges, ABC securities are traded at ₹150. So, the trader will buy stocks at ₹100 and sell for ₹150 on the other stock exchange.

Process of Commodity Trading

To understand commodity trading, you need to understand the whole concept of derivatives. For example, suppose a person has bought a derivative contract that is a put option. The person chooses to hold the option until the date of exercise and then sell the underlying asset at the strike price.

In an option contract, if the spot price of the contract is ₹500 and the strike price is ₹700, then the trader can get the higher rate to sell at a higher rate. But if the spot price is ₹800, then the put option is not advisable at ₹700. Now, the put option holder may choose to hold the contract, suffer the loss of the entire option premium or wait for another buyer to buy the contract giving him the proper exit.

These buying and selling of contracts are called derivatives. In the stock market, traders study the future projection of a financial asset and then choose the asset as per their requirements.

Margin in Derivatives Trading

Trading in derivatives requires huge funds, and the risk and reward are quite high in these trades. As a trader, you need to deposit a small percentage of your trade. This small percentage of your margin money which you can borrow from brokers to trade in the derivative market. A broker asks for the percentage of money and later you need to pay back the loan amount along with the interest applicable on the leverage amount.

Some of the charges applied to derivative trading are:

• Brokerage charges
• Stamp duty
• Integrated Goods and Service Tax

Conclusion

In conclusion, derivative trading in the share market is a dynamic and integral aspect of modern financial markets, offering investors a range of tools to manage risk, speculate on price movements, and diversify their portfolios. The flexibility provided by derivatives allows market participants to adapt to changing conditions, make strategic investment decisions, and navigate the complexities of the share market. However, it is crucial for investors to approach derivative trading with a comprehensive understanding of the associated risks and market dynamics, ensuring informed decision-making for optimal financial outcomes.

Frequently Asked Questions (FAQs)