Theunjob finance A Guide To Derivatives In The Context Of The Stock Market

A Guide To Derivatives In The Context Of The Stock Market

Time has stood as a witness to the growing demands of infusing technology with convenience to increase the reach of the concept of stock trading. And, we can see that this demand has summoned responses in the form of stock trading apps. Although trading apps have equipped individuals with all they need to open a Demat account online, they haven’t necessarily equipped individuals with the skills and knowledge they need to succeed as stock investors. Consequently, many investors overlook advanced investment options, such as derivatives, and don’t invest in F&O stocks.

What are derivatives?

Derivatives are contracts or financial instruments that derive their value from the assets they’re based on. Initially, a base collection of assets is established, which can include stocks, bonds, currencies, indices, and other commodities. The value of the underlying assets is subject to fluctuations depending on changing market conditions, resulting in fluctuation of the value of the overall derivative. 

Types of Derivatives

1. Forwards

Forwards are customized agreements between two parties to purchase or sell an asset or other commodity at a predetermined price in the future. Forwards lack standardization and regulatory oversight. Thus, they’re primarily employed for risk mitigation, with no assurance of generating profits.

2. Futures

They are financial agreements that share a fundamental resemblance to forwards. However, the key distinction between forwards and futures lies in the fact that future trading can be done on exchanges, making them standardized and subject to regulation.

3. Options

Options are financial agreements in which the buyer or seller holds the right to purchase or sell a security or financial asset, but isn’t necessarily obligated to do so. Commonly, investing in futures and options is referred to as F&O trading

Options trading shares a commonality with Futures, as they involve a contractual arrangement between two parties to buy or sell securities at a prearranged price in the future. Importantly, these parties are not legally bound to fulfill their side of the agreement; they can choose whether to execute the purchase or sale at the agreed-upon time. 

4. Swaps

Swaps represent a type of financial derivative frequently used to swap one form of an underlying asset for another. Swaps are usually privately negotiated agreements between different parties and may not be exchange-traded instruments.

How are Derivates Related to the Stock Market?

Imagine you decide to buy a derivative or a contract from a company’s shares. The current price for that company’s stocks is 3000 rupees, and the contract says that you can buy that stock at the same price after a month. A month later, if the price of the shares increases to 3500 rupees, and you buy the same stocks at a price of 3000, you would get a profit of 500 rupees.

However, if the price of the same stock doesn’t change or if it drops, you would have to incur a loss. The same idea applies to trading contracts on stock market indices, like Nifty50.

Advantages of Derivatives:

  • Risk mitigation: By locking in the prices of the underlying assets, an investor can lower the overall risk in their investment. 
  • Lower transaction costs: Derivatives can be traded with a lower transaction cost, as their primary purpose is to mitigate risks.

Before investing in derivatives, like F&O, it’s crucial to understand how it’s done. It’s also important to note that the strategy that you would employ in derivatives trading won’t necessarily be the same as you use while trading stocks. Thus, it’s highly advisable to use all resources available online to understand how derivatives trading is done.

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