What are Derivatives and their Types in Stock Market? | Example

What are Derivatives and their Types

This article will examine what are Derivatives and their Types.
Here are some key points to understand about derivatives in the stock market:

1. Derivatives are financial instruments that derive their value from an underlying asset, such as a stock, commodity, or currency.
2. The value of a derivative is based on the price movements of the underlying asset.
3. There are various types of derivatives in the stock market, including futures contracts, options, and swaps.
4. Futures contracts are agreements to buy or sell an underlying asset at a specified price on a specific date in the future.
5. Options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specific date.
6. Swaps are agreements between two parties to exchange cash flows based on the price movements of an underlying asset.
7. Derivatives can be used for hedging or speculation. Hedging involves using derivatives to protect against potential losses from adverse price movements, while speculation involves using derivatives to profit from price movements.
8. Derivatives trading can be risky, as it involves leverage, which amplifies potential gains and losses.
9. Regulations for derivatives vary by country, and some jurisdictions have implemented stricter rules to reduce the risks associated with derivatives trading.

Derivatives Types

here are the types of derivatives that are commonly traded in the Indian stock market:

1. Futures:
   Futures contracts are agreements to buy or sell an underlying asset at a predetermined price and date in the future.
2. Options:
   Options contracts give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specific date. Options trading in India is available for stocks, indices, and currencies.
3. Index futures:
   Index futures are futures contracts that allow investors to buy or sell an index of stocks at a predetermined price and date in the future. These contracts are settled in cash and are commonly used for hedging and speculation.
4. Index options:
   Index options are options contracts that give the buyer the right, but not the obligation, to buy or sell an index of stocks at a specified price on or before a specific date. These contracts are also settled in cash and can be used for hedging and speculation.
5. Currency futures:
   Currency futures are futures contracts that allow investors to buy or sell a particular currency at a predetermined price and date in the future. These contracts are traded on various currency pairs, including USD/INR, EUR/INR, and JPY/INR.
6. Currency options:
   Currency options are options contracts that give the buyer the right, but not the obligation, to buy or sell a particular currency at a specified price on or before a specific date. These contracts are also traded on various currency pairs in the Indian stock market.

NSE Derivatives Stock List

The National Stock Exchange of India (NSE) offers derivatives trading on a variety of stocks. Here is a list of some of the most actively traded stocks on the NSE derivatives segment:

1. Reliance Industries Limited (RELIANCE)
2. State Bank of India (SBIN)
3. Housing Development Finance Corporation Limited (HDFC)
4. Infosys Limited (INFY)
5. Tata Consultancy Services Limited (TCS)
6. ICICI Bank Limited (ICICIBANK)
7. Axis Bank Limited (AXISBANK)
8. Larsen & Toubro Limited (LT)
9. Hindustan Unilever Limited (HINDUNILVR)
10. Kotak Mahindra Bank Limited (KOTAKBANK)

Note that this list is not exhaustive and there are many other stocks that are available for derivatives trading on the NSE. The availability of stocks for derivatives trading may also change based on market conditions and regulatory requirements.

Example

here are a few examples of derivatives trading in the Indian stock market:

1. Futures trading:
   Suppose an investor believes that the stock of a particular company is going to rise in the near future. They can buy a futures contract on that stock, which will allow them to purchase the stock at a predetermined price at a future date. If the price of the stock rises above the futures price, the investor can make a profit.
2. Options trading:
   Suppose an investor holds a stock in their portfolio and is concerned about a potential drop in the stock's price.
   They can purchase a put option on that stock, which will give them the right to sell the stock at a predetermined price.
   If the stock price falls below that price, the investor can sell the stock at a profit.
3. Hedging:
   A company that relies heavily on a particular commodity, such as oil, may use futures contracts to hedge against price fluctuations.
   By purchasing futures contracts on oil, the company can lock in a price for the commodity, ensuring that they can purchase it at a fixed cost even if the price of oil rises.
4. Speculation:
   Traders may also use derivatives to speculate on the price movements of various assets.
   For example, a trader may buy a call option on a stock they believe will increase in price,
   hoping to make a profit from the difference between the strike price and the market price of the stock. Alternatively, a trader may sell a futures contract on a stock they believe will decrease
   in price, hoping to profit from the difference between the futures price and
   the market price when the contract expires.

Invest in Derivatives

Investing in derivatives can be a complex and risky endeavor, and should only be undertaken
after careful consideration of the risks and benefits involved. Here are some factors to consider
if you are thinking about investing in derivatives:

1. Understand the nature of derivatives:
   Derivatives are complex financial instruments whose value is based on an underlying asset, such as a stock, commodity, or currency.
   They can be used for speculative purposes, hedging, or to gain exposure to asset classes that may not be available through traditional investment vehicles.
2. Learn about the different types of derivatives:
   The most common types of derivatives are futures, options, forwards, and swaps.
   These contracts differ in terms of the nature of the underlying asset, the time frame of the contract, and the obligations of the parties involved.
3. Consider the risks involved:
   Derivatives can be highly leveraged, meaning that a small change in the underlying asset's price can have a significant impact on the value of the contract.
   They can also be subject to counterparty risk, which is the risk that one party to the contract will default on its obligations.
   Additionally, derivatives can be complex instruments that require a deep understanding of the underlying assets and the terms of the contract.
4. Evaluate your risk tolerance:
   Investing in derivatives can be risky, and you should only invest in derivatives if you have a high tolerance for risk. You should also have a clear understanding of your investment goals and how derivatives fit into your overall investment strategy.
5. Consult with a financial advisor:
   If you are considering investing in derivatives, it's important to consult with a financial advisor who can help you assess your risk tolerance and determine whether derivatives are a suitable investment for your portfolio.

FAQs