The world of trading is filled with terms like Futures and Options, yet many market participants are unsure about what they truly mean. These instruments belong to a broader category called derivatives, which are financial contracts whose value is linked to an underlying asset such as stocks, commodities, currencies, or market indices. Instead of directly owning the asset, derivatives allow participants to manage risks, speculate on price movements, and gain exposure with less capital.
In this blog, we will explore derivatives, Exchange Traded Derivatives, their features, types, advantages, disadvantages, and frequently asked questions.
What are Derivatives & Why Trade on an Exchange?
A derivative is a financial contract whose value is derived from the performance of an underlying asset, index, rate, or commodity. This “underlying asset” can be anything from a share of a company (like TCS), a commodity (like gold), a currency (like the US Dollar), or even a stock market index (like the Nifty 50).
Issues in Private Deals
In finance, when two parties create a derivative contract privately without using an exchange, it is called an Over-the-Counter (OTC) derivative. These contracts can be customized to suit the needs of the parties involved, but they also come with risks as mentioned below:
- Counterparty Risk: It’s the risk that the other party in the deal might not fulfill their part of the agreement.
- Undisclosed Details: The price and terms are just between both the parties, nobody else knows the details, which can lead to someone getting a raw deal.
Example: Consider two friends. Ramesh, a wheat farmer, is worried that prices may fall by the time his crop is ready in three months. Suresh, who runs a biscuit factory, fears wheat prices may rise and increase his costs. To reduce uncertainty, they agree that Ramesh will sell 100 quintals of wheat to Suresh in three months at a fixed price of ₹2,000 per quintal.
This arrangement protects both of them from price swings, but since it is a private contract, it carries the same risks of an OTC deal. Ramesh worries Suresh may not pay, while Suresh worries Ramesh may not deliver.
Why Exchange?
To fix the loop holes and issues, we have exchange traded derivatives (ETDs). Instead of people dealing directly with each other, they trade these contracts on a regulated stock exchange, like the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE) in India. Think of these exchanges as a trustworthy platform that stands in the middle of both the parties and makes sure everyone follows the rules. The presence of an exchange makes everything safer, transparent, making derivatives available to millions of people, including regular investors like you and me.
| Feature | Exchange-Traded Derivatives (ETD) | Over-the-Counter (OTC) Derivatives |
|---|---|---|
| Trading Venue | Traded on a recognized exchange (e.g., NSE, BSE) | Traded privately between two parties |
| Contract Terms | Standardized (fixed size, expiry date) | Customized to fit specific needs |
| Counterparty Risk | Very low, as the exchange guarantees the contract rules are followed | High, as one party could default |
| Transparency | High, prices and volumes are public | Low, terms are private |
| Regulation | Regulated by bodies like SEBI | Less regulated |
| Suitable For | Retail investors and institutions | Mainly large institutions and corporations |
Read Also: What is Derivative Trading? Types, Examples, Pros & Cons Explained
Features of Exchange Traded Derivatives
- Standardization: All the derivatives of contracts on an exchange are standardized. This means there are fixed rules, like the quantity also known as “lot size”, the quality of the asset, and the end date.
- Reduced Risk: This is a major advantage. When you trade on an exchange, the clearinghouse acts as a middleman, ensuring that even if one party defaults or goes bankrupt, the trade is still completed as agreed.
- High Liquidity: As traders trade on the same standardized contracts on big platforms like the NSE, there are always tons of buyers and sellers around. This is known as high liquidity, it is great because it means investors can easily buy or sell a contract almost instantly at a fair price.
- Transparency: On an exchange, trades happen transparently, all the buy and sell orders are visible to traders in real time. The price you see is the real price, based on supply and demand of assets.
- Regulations: In India, Securities and Exchange Board of India (SEBI) sets the rules of the trading market for exchanges and brokers to make sure the market is fair and safe for everyone. SEBI’s main job is to protect your interests as an investor, keeping a close eye on all the trading activity.
Read Also: Index Derivatives in India
Types of Exchange Traded Derivatives
In India, you can trade derivatives on most of the things, but mainly in Futures and Options. These can be based on:
- Stock Derivatives: These are futures and options on the shares of individual companies like Reliance, Infosys, or HDFC Bank.
- Index Derivatives: These are contracts based on a stock market index, like the Nifty 50 or Bank Nifty. Instead of putting all your money on one company, you’re taking a view on the whole market or a specific sector.
- Commodity Derivatives: These are contracts on physical goods, you can trade them on exchanges like the Multi Commodity Exchange (MCX), like gold, silver, crude oil, and even some agricultural products.
- Currency Derivatives: These contracts are based on currency pairs, like the US Dollar vs. the Indian Rupee (USD/INR). Currency derivatives are a lifeline for importers and exporters who need to protect themselves from fluctuating exchange rates.
- Interest Rate Derivatives: These are a bit more complex and are based on bonds and interest rates. They are mostly used by banks and financial institutions to manage risks related to the changing interest rates.
Advantages and Disadvantages of Exchange Traded Derivatives
Advantages
- Risk Management: Derivatives are highly used for managing risk. Investors can use them to protect their stock portfolios from sudden market shifts.
- High Leverage: Leverage means you can control a large position of stocks with a small amount of money also called margin.
- Transaction Costs: Compared to normal buying and selling of stocks in the regular cash market, the costs of trading a futures contract (like brokerage and taxes) can be lower.
Disadvantages
- Leverage Risks: Just as leverage can magnify your profits, it can also amplify your losses quickly. A small price movement in other direction can wipe out your entire investment, and you could even end up owing your broker money.
- Complex: Derivatives are not for beginners as it is complex, concepts like expiry dates, option pricing models, and complex strategies can create difficulty in beginning. Trading without proper knowledge can lead you to losses.
- Time Decay: Options contracts have a limited shelf life as there is a pre defined expiry date. This is known as time decay, if your prediction doesn’t come true in time, your option can expire becoming worthless, and you lose all the money.
Read Also: Different Types of Derivatives in India
Conclusion
Exchange traded derivatives are a powerful and vital part of the modern financial world. They offer ways for businesses to manage risk and for traders to act on their market views. The safe and open environment of the stock exchange has made them available to almost everyone.
The same leverage that can lead to amplifying investors profits can also cause great losses. These are not tools for beginners, before entering into trading your first derivative contract, the best investment you can make is in gaining knowledge and deeper insight.
| S.NO. | Check Out These Interesting Posts You Might Enjoy! |
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| 1 | What is Swaps Derivatives? |
| 2 | What is AI Trading? |
| 3 | What is an Underlying Asset? |
| 4 | Different Types of Trading in the Stock Market |
| 5 | What is Intraday Trading? |
| 6 | Types of Futures and Futures Traders |
Frequently Asked Questions (FAQs)
Difference between buying a Reliance share and a Reliance future?
When you buy a share of Reliance, you pay the full price of the stock upfront and become a part-owner of the company. When you buy a Reliance future, you’re just signing a contract to buy or sell the share at a future date for a set price. You only pay a small margin upfront and don’t actually own the share.
What is meant by Lot Size?
A lot size is the fixed number of units in one derivative contract. For example, if the lot size of future contact is 500, you have to trade in multiples of 500. Investors can’t just buy a contract for 1 or 10 shares.
What is an “Expiry Date” in Derivatives?
This is the end date till the derivative contract is valid. Based on expiry date, the contract is settled, either by delivering the asset or by commonly settling the profit or loss in cash.
Are ETDs safe for new investors?
While the exchange protects you from the counterparty defaulting, derivatives are extremely risky for beginners because they are complex and highly leveraged. It is highly recommended that new investors should gain knowledge and understand all the risks before putting your money.
Do Investors need a special account for trading via trade derivatives?
Yes, you use your Demat and Trading account, but you have to get the “Futures & Options” (F&O) segment activated by your stock broker. This requires proof of income, as brokers need to ensure you can handle the high financial risks involved.
