Let's say you're a portfolio manager who manages an extensive portfolio of stocks. You're concerned that the overall market might experience a downturn shortly, which could negatively impact the value of your portfolio.
To hedge against this risk, you could engage in derivative trading by purchasing Put options on the Nifty.
In this way, if the market does experience a downturn, you can sell your put options at a profit, which would offset some of the losses in your stock portfolio. But as a retail investor, can you implement this strategy?
In this blog, we will help you understand derivative trading, the types of derivative contracts and the risks involved in derivative trading in India. We will also try to understand if trading in derivatives is for you, but first...
What Is Derivative Trading?
Let’s understand derivatives before we dive into derivative trading.
In short, a derivative is a contract between two parties (buyer and seller) who try to come into an arrangement to exchange a given asset on a future date by buying or selling a contract for the same.
Imagine derivatives as a token amount paid to book an apartment at the current price. After you have booked, the apartment will be reserved at your booked price. However, If the prices fall, you can cancel the contract and place another order at a lower price. Similarly, financial derivatives can be for an underlying asset, a group of assets, or a benchmark.
Derivatives allow investors to speculate on the direction of the underlying asset's price movements, hedge against potential losses, and manage risk.
Buying and selling financial contracts whose value is derived from an underlying asset, such as stocks, bonds, or commodities, is known as derivative trading.
Types Of Derivatives
Different derivative contracts exist, such as forward contracts, futures contracts and options contracts. Forward contracts are customised agreements between two parties to buy or sell an asset at a specific price and date in the future. In contrast, futures contracts are standardised agreements traded on an exchange and commonly used in commodities trading.
Options contracts are derivatives that grant the holder the right to buy or sell an underlying asset at a predetermined price and date in the future.
Let’s understand this better with an example. One example of a futures contract on oil in the Indian market is the MCX crude oil futures contract. This contract is traded on the Multi Commodity Exchange of India (MCX). It allows buyers and sellers to agree to buy or sell a specific quantity of crude oil at a predetermined price on a future date.
For instance, say you want to secure a price for crude oil. You can enter into a futures contract to purchase 100 barrels of crude oil at Rs 5,000 per barrel, with a delivery date in April. If the price of crude oil increases to Rs 5,500 per barrel by the delivery date, you will profit by Rs 50,000 (Rs 5,500 - Rs 5,000 x 100). On the other hand, if the price of crude oil drops to Rs 4,500 per barrel, you will lose Rs 50,000 (Rs 5,000 - Rs 4,500 x 100).
Risks Involved In Derivatives Trading
Trading in derivatives involves high risk and is unsuitable for all investors. Here are some of the risks involved in derivatives trading:
- Market Risk
Derivative instruments are sensitive to changes in market prices and conditions. The value of the derivatives may vary due to changes in the prices of the underlying assets, interest rates, exchange rates, and other economic factors.
- Liquidity Risk
Liquidity risk refers to the risk of being unable to exit a position in a derivative instrument at a fair price due to a lack of market participants or market disruptions.
- Counterparty Risk
Counterparty risk arises when one of the parties in a derivatives transaction defaults or fails to honour the contract. This can result in significant losses for the other party. This mostly happens in over-the-counter transactions that are unregulated.
- Operational Risk
Operational risk arises from inadequate or failed internal processes, systems, human errors, or external events that affect a company’s ability to conduct its operations.
- Legal and Regulatory Risk
Derivatives trading is subject to various legal and regulatory requirements that can change over time, creating uncertainty and potential risk for investors.
Steps To Trade Derivatives In India:
Here is a 5 step process with which you can trade derivatives in India
- Open a trading account with a broker
To trade in derivatives, you must have a trading account with a broker registered with the stock exchanges. You can choose from several brokers in India, including full-service brokers and discount brokers.
- Fund your trading account
Once you have opened a trading account, you need to fund it by transferring money from your bank account to your trading account.
- Enable the derivatives segment
Since derivatives are high-risk instruments, you must provide documents like income proof, ITR, Demat holding, etc., for the broker to enable this segment.
- Place an order
Once you can access derivatives, you can order to buy or sell index/stock options and futures through your broker's trading platform. You must specify the underlying index, the option type (call or put), the strike price, and the expiry date. You can also select the quantity and price you want to trade.
- Monitor your position
Once your trade is executed, you must monitor your position regularly to determine if you want to exit your position early or let it expire.
Advantages and Disadvantages Of Derivative Trading For Retail Investors
Derivative trading can offer both advantages and disadvantages for retail investors. Some of its advantages include:
- The potential for high returns is one of the main advantages of trading in derivatives.
- Derivatives allow investors to amplify their returns through leverage, which means that even small price movements can lead to significant gains.
- Additionally, derivatives can be used for hedging and risk management purposes, which can help investors protect their portfolios from downside risk. This is especially important in highly volatile markets.
- Derivative trading also provides an opportunity for diversification. Derivatives can provide exposure to a wide range of asset classes, including equities, commodities, currencies, etc. Derivatives also allow you to build strategies and limit your losses, which increases your profit probability, and at the same time, restricts your losses.
However, there are also potential disadvantages to derivative trading.
- One of the biggest concerns is the costs and fees associated with trading derivatives. Usually, the brokerage on futures and options is charged on a per lot or order basis, which can be very high compared to equity.
- Another major disadvantage is the potential for significant losses. Since derivatives are highly leveraged instruments, even small price movements in the underlying asset can result in substantial losses for traders.
- Then there is liquidity risk, in which you could get stuck with a contract without sufficient liquidity, which can lead to the delivery of the underlying. This can be a massive blow for small retail trades.
Should You Trade Derivatives?
Looking at all the above pointers, it can be said that although derivative contracts involve many risks, they can be helpful when used carefully. If you want to try your hand at Derivatives trading, index options can be something that you can consider. Index options also offer several advantages over other financial instruments. For example, they allow traders and investors to hedge against market risks and volatility, which can be particularly useful in times of economic uncertainty. These contracts are settled in cash, which means there is no risk of delivery of the underlying. They also provide a way for investors to gain exposure to the broader stock market rather than individual stocks.
However, derivative trading may not be a viable option for beginner retail investors who are just starting in the stock markets due to the complexity of derivative products and high leverage. Still, if you are considering trading in derivatives, it is crucial to carefully weigh the potential benefits of derivative trading against the risks and costs involved. You should also consider your risk tolerance and investment objectives and take guidance from professionals if required.
- Derivative trading involves contracts to exchange assets in the future, allowing investors to speculate, hedge, and manage risk.
- Types of derivatives include forward contracts, futures contracts, and options contracts.
- Risks in derivative trading include market, liquidity, counterparty, operational, and legal/regulatory risks.
- To trade derivatives in India: open a trading account, fund it, enable the derivatives segment, place an order, and monitor your position.
- Advantages of derivative trading: potential high returns, leverage for amplified gains, hedging and risk management, and diversification. Disadvantages include high costs, potential losses, and liquidity risks.
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