Financial contracts whose value is dependent on an underlying group of assets or a single asset are called Derivatives. The underlying assets could be currencies, commodities, market indices, stocks or bonds. The underlying assets trade in the cash or spots market. The prices of the underlying assets are called cash or spot prices or simply stock prices.
The derivative contract is based upon earning profits through speculations on how the value of the underlying asset will change in the future. These contracts are entered into by individuals or institutional investors. These investors may be margin traders, hedgers and speculators who enter into contracts like futures, options or swaps to book profits or reduce risks
There are two ways of trading in derivatives. These are over the counter ( OTC) or trading on an exchange. Futures and options are exchange traded contracts while an OTC may also include swaps and forwards in addition to the futures and options. Over the counter trading is not as structured as the exchange traded contracts and are more private in nature and known only to the traders who enter into the contract.
The options that the trader bets in could be a call or a put. A call option is when the trader feels the price of the underlying asset will go up and the put option is done when the trader speculates that the price of the underlying asset will fall.
| Derivative contract | What it means |
|---|---|
| Futures | This is a contract between the buyer and seller where the buyer agrees to pay a stipulated price for buying or selling stocks on or before a particular date. |
| Options | This contract grants the buyer the right to buy or sell the underlying asset at a certain price on or before a certain date. |
| Swaps | In this contract two parties exchange their financial obligations based on a notional amount mutually agreed upon. Swaps are only done OTC contracts between businesses or financial companies. |
| Forwards | These are like futures contracts and the obligation is to pay a certain amount at a future date. However forwards contracts are done over the counter and can be customized as per the parties entering into the contract. |
For trading in derivatives, you have to open a Demat account through a stockbroker. The broker will ask you for your KYC documents like pan card, address proof, bank statement, income proof etc.
You are required to deposit a certain amount called the margin amount to start trading in the derivative market. This margin amount stays deposited until the trading is not settled. Moreover the amount has to be replenished if it falls below the minimum level. Then you can start trading by choosing the stocks or shares.
