Types of Derivatives: Understanding Futures, Options, and More

Derivatives are financial contracts whose value is derived from the price of an underlying asset. These underlying assets can be anything from stocks, commodities, and currencies to interest rates and market indices. Types of derivatives include a wide variety of financial instruments, with futures and options being two of the most commonly traded ones. Understanding these derivative types can provide investors with the tools to hedge against risks in financial markets.

In this article, we’ll explore the different types of derivatives, how they work, and why investors need to open demat account to trade these instruments.

What are derivatives?

Derivatives are contracts between two or more parties that derive their value from an underlying asset. Unlike direct investments in stocks or commodities, derivatives are used to hedge against the future movement of the asset's price without owning the asset itself.

Some common underlying assets for derivatives include:

●Stocks

●Commodities

●Bonds

●Currencies

●Interest rates

●Market indices

Derivatives are often used by investors to manage risk. Let's take a closer look at the key types of derivatives.

Types of derivatives

1. Futures

A futures contract is a legal agreement to buy or sell an asset at a predetermined price on a specific future date. These contracts are traded on exchanges, and they can be used for a wide range of assets, including commodities, stocks, and bonds.

Futures are widely used by both investors and companies to hedge against price fluctuations. For example, a farmer might sell a futures contract on their crop to lock in a price before the harvest. On the other hand, an opportunist might use a futures contract to take chance on the price of gold increasing in the future.

Key features of futures:

●Standardised contracts: All futures contracts are standardised in terms of the quantity and quality of the underlying asset.

●Leverage: Futures trading typically involves leverage, meaning you can control a large position with a relatively small investment.

●Mark-to-market: Futures positions are marked to market daily, meaning gains or losses are recorded at the end of each trading day.

2. Options

Options are another type of derivative that gives the holder the right (but not the obligation) to buy or sell an asset at a predetermined price within a specified time frame. There are two types of options: call options and put options.

●A call option gives the holder the right to buy an asset.

●A put option gives the holder the right to sell an asset.

Unlike futures, options provide flexibility, as the buyer is not obligated to execute the contract. However, the seller is obligated to buy or sell the asset if the option holder decides to exercise the contract.

Key features of options:

●Limited risk for buyers: The buyer of an option can only lose the premium paid for the contract, which limits their risk.

●Potential for large gains: If the price of the underlying asset moves significantly, the holder of an option can earn substantial profits.

●Time decay: The value of an option decreases as the expiration date approaches, a phenomenon known as time decay.

3. Swaps

A swap is a derivative contract in which two parties exchange cash flows or other financial instruments over a specified period. The most common type is the interest rate swap, where one party agrees to exchange a fixed interest rate for a floating rate with another party. Swaps are generally used to manage interest rate risks or to gain exposure to different types of interest payments.

Key features of swaps:

●Over-the-counter (OTC): Unlike futures and options, swaps are typically traded over-the-counter, meaning they are privately negotiated.

●Customisable: Swap agreements are tailored to meet the needs of both parties involved.

4. Forwards

Forward contracts are similar to futures, but they are privately negotiated and traded over-the-counter. In a forward contract, two parties agree to buy or sell an asset at a specified price on a future date. Because they are customised, forward contracts can include specific terms and conditions that meet the needs of the parties involved.

Key features of forwards:

●Not standardised: Forward contracts are customised to the needs of the buyer and seller, unlike standardised futures contracts.

●Settlement risk: Since forwards are not traded on an exchange, there is a higher risk of default by either party.

Why you need to open demat account for trading derivatives

To trade derivatives like futures and options, you need to open demat account. A demat account is essential for holding financial securities in an electronic form, and it is required for trading in stock markets. Opening a demat account offers several advantages, including:

1.Safe and secure storage: A demat account holds your securities electronically, reducing the risk of loss or theft.

2.Easy transactions: Buying and selling derivatives, such as futures and options, becomes easier and faster with a demat account.

3.Streamlined management: With a demat account, you can manage your holdings and transactions from a single platform.

By having a demat account, you gain access to various derivative products and can execute trades efficiently.

Key considerations when trading derivatives

1. Understand leverage and risk

Leverage allows you to control a large position with a smaller amount of capital, but it also magnifies both gains and losses. Before trading derivatives, it’s crucial to understand how leverage works and to use risk management strategies like stop-loss orders.

2. Market volatility

Derivatives trading is highly sensitive to market fluctuations. Understanding the volatility of the underlying asset is essential for making informed trading decisions. Keeping an eye on economic events and market trends can help you navigate price swings more effectively.

3. Choose the right strategy

Each type of derivative serves a different purpose. Determine whether you are trading for hedging or arbitrage, and select the strategy that aligns with your financial goals.

Conclusion

Derivatives, including futures, options, swaps, and forwards, play an essential role in modern financial markets. Understanding the types of derivatives and their uses can help you make informed trading decisions, whether you’re looking to hedge risks on market movements. When you open demat account, you can gain access to the world of derivatives trading and take advantage of the opportunities they offer. However, always remember that trading derivatives comes with inherent risks, and proper risk management is key to success.

(No Hans India Journalist was involved in creation of this content)