Have you ever wondered what is derivative market? What are the different types of derivatives? How to make money in the derivatives market and through many types of derivatives?. You may know that derivatives are financial securities whose value or price is derived from an underlying asset or a group of assets. These assets can be stocks and currencies, among others. Both seasoned long-term investors and savvy short-term traders use different types of derivatives to either hedge portfolio or to gain from sharp movements in prices. Before you begin derivatives market trading, find out 10 important things you must know. Read on.
Many people ask what is a derivative?. Derivatives are a useful financial instrument. By using different types of derivatives, you can remove the need to invest a large amount of capital upfront. A derivative allows you to benefit from market movements. If you are good at anticipating market movements, derivatives are a good friend since they allow you to ear returns quickly. They also double up as an effective tool to hedge risks. The classical derivative definition is - A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset or set of assets. This is how many define derivative. Next, we will learn what are the advantages of trading in types of derivatives.
What are the key benefits of derivative trading
There are 4 main benefits of derivating trading.
1. Gain leverage - Derivative trading enables you to get higher trading exposure with a low margin amount.
2. Do hedging - Derivative trading allows you to de-risk yourself by hedging your positions. You can buy in the cash segment and agree to sell in the derivative market or vice versa.
3. Opt for risk as per choice - Derivative trading allows you to choose between conservative or high-risk strategies, These could be based on the expected rise and fall of stock prices/indices.
4. Access higher returns - With derivative trading, you have a possibility to get returns irrespective of market moving up, down or sideways.
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The definition of derivative told us how it is a contract. Well, one can trade in many types of derivative contracts.
Firstly, there are Futures. These are derivative contracts or agreements between the two parties to either buy or sell a fixed quantity of an asset at a particular time in the future for a fixed price. Most of the futures contracts are cash settled, which means only the cash differential is paid out. The 'lot size' specifies the minimum quantity that you will have to transact in a futures contract. Also, the contract value of a futures contract agreement is the 'lot size' multiplied by the price.
In a futures contract agreement, both the parties involved will have to deposit some money as a token advance required for entering into an agreement. The money has to be deposited with the broker. This initial money is a percentage of the contract value, and is called the 'margin amount'. Lastly, every futures contract has an expiry date - beyond which the contract would cease to exist. Upon the expiry of old contracts, new futures contracts are created.
Remember the derivative definition? No? It is okay. The main difference between derivative and equity is the driver of the value or price. Equity gets its value based on market conditions such as demand and supply and company/economy related events. A derivative, on the other hand, derives value or price from the underlying asset such as index, stock, currency, etc. You can take a look at the f&o stocks list and decide which one to trade when it comes to specific equity securities.
It is important to note that the words 'equity derivatives' are often used together. They are used to signify a class of derivatives whose value is at least partly derived from one or more underlying equity securities or indices. Futures and options, commonly referred to as F&O, are the most common equity derivatives.
Before derivative trading began, NSE and BSE stock exchanges were examples of electronic equity spot markets. Derivatives trading started in June 2000. Stocks and derivatives trading volumes helped NSE and BSE emerge among the top 10 exchanges in the world by virtue of the number of transactions.
Initially, there were Nifty futures. Then, options were launched. Currency derivatives trading commenced in mid-2008.
The National Stock Exchange of India Limited (NSE) started trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark index --- Nifty 50.
The NSE introduced trading in Index Options (also based on Nifty 50) on June 4, 2001. It then launched trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced by the NSE on November 9, 2001. Futures and Options on individual securities are available on over 190 securities. You can get them on the f&o stocks list.
The NSE has also introduced trading in Futures and Options contracts based on Nifty IT, Nifty Bank, and Nifty Midcap 50, Nifty Infrastructure, Nifty PSE, Nifty CPSE indices.
All these products comprise the NSE equity derivatives bouquet.
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The Nifty 50 Futures is a forward contract. The NSE defines the characteristics of a futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.
Nifty 50 futures contracts have a maximum of the 3-month trading cycle. 1. the near month (one); 2. the next month (two) and 3. the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. Nifty 50 futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
Nifty 50 options contracts have 3 consecutive monthly contracts. Plus, they have 3 quarterly months of the cycle March / June / September / December and 5 following semi-annual months of the cycle June / December would be available. At any point in time, there would be options contracts with at least 3-year tenure available. On the expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract.
Nifty 50 options contracts expire on the last Thursday of the expiry month. Like the Nifty 50 Futures, if the last Thursday is a trading holiday, the Nifty 50 Options contracts expire on the previous trading day.
Open Interest or OI is a number that tells you how many futures or options contracts are currently outstanding i.e. open in the market.
Open interest gives you a sense of strength between bullish and bearish positions.
If price and OI both increase, then there are more trades on the long side.
If price and OI both decrease, then this means that traders who are long are covering their position. This is also called long unwinding.
If price decreases but OI increases, that there are more trades on the short side.
If price increases but OI decreases, then this means that traders who are short are covering their position. This is also called short covering.
Always remember that if there is an abnormally high OI with a rapid increase or decrease in prices, then as a derivatives trader you should be cautious. This situation indicates there is a lot of euphoria and leverage in the market.
F&O trades or derivative trades have become lead indicators for the market. Apart from looking at leverage levels, traders see when FIIs are long with huge positions. This is because any small negative news leads to unwinding and vice versa.
An unwinding of long positions in F&O puts pressure on the cash market even if there is no actual selling happening in a big way.
FII play in derivatives also leads to arbitrage in the cash market.
FIIs with a strong back-up of significant holding in most index heavyweights often raise their play in the F&O segment.
On NSE, there are 2 major products under equity derivatives. They are NSE Futures and NSE Options, which are available on Indices and Stocks. There are over 190 individual shares in the F&O stocks list on the NSE. They include ACC, Bharti Airtel, Canara Bank, DLF, Grasim, HDFC, ITC, Sun Pharma, Reliance Industries etc.
BSE launched the first Exchange-traded Index Derivative Contract in India i.e. futures on the capital market benchmark index - the BSE Sensex in June 2000. The BSE commenced trading in Index Options on Sensex in June 2001. BSE Stock Options were introduced in July 2001 and Single Stock Futures were launched in November 2002.
BSE also introduced Long Dated Options on its flagship index - Sensex in February 2008. This allowed you to trade in Sensex Options contracts with an expiry of up to 5 years.
Currency derivatives in India are in the form of currency futures, also known as FX future.
A currency futures contract is there to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. In India, settlement of all currency derivatives happens on the last working day of the month.
On NSE, the price of a futures contract is in terms of INR per unit of other currency e.g. US Dollars. Currency futures contracts allow investors to hedge against foreign exchange risk. The exchange launched its currency futures trading platform in August 2008.
Currency derivatives are available on four currency pairs viz. US Dollars, Euro, Great Britain Pound, and Japanese Yen. Cross Currency Futures & Options contracts on EUR-USD, GBP-USD, and USD-JPY are also available for trading in currency derivatives space.
In October 2008, BSE launched its currency derivatives segment in US Dollar-Indian Rupee currency futures.
Depending upon your preference, you can choose to trade currency derivatives nse or currency derivatives bse.
When you buy equity derivatives, you are expecting some movement (up or down) in the underlying equity index or stock.
But, when you buy currency derivatives, you are taking a bet on a currency pair i.e. dollar-rupee. You are either expecting the dollar to appreciate or depreciate against the rupee.
We hope you now understand the derivative meaning, the different types of derivatives and the nitty gritty of what is derivative market.
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