What is a Derivative Contract: Meaning, Types, Uses?

A whopping 18,66,01,40,821 derivative contracts were traded on NSE in 2021-22. These derivatives were worth an eye-watering amount of Rs. 1,69,52,33,134 crores! Okay… 

But what is a derivative contract and why is each one worth so much money? We’re going to help you find out! Here’s what you’ll understand about derivatives in this blog 👇

What is a Derivative in Simple Terms?

A derivative is a contract that derives its value from underlying assets like stocks, commodities, currencies, and others. That’s why these contracts are called “derivative” contracts.

Just like any other contract, a derivative is an agreement between two parties to buy and sell an underlying asset at a pre-agreed price and date. Every party has a vested interest in the underlying asset’s price as they may want to:

• Hedge: protect their business or themselves from unfavourable price fluctuations 
• Speculate: benefit from the fluctuations in the price of an underlying asset to generate returns

Believe it or not, derivative trading stretches back to the era of Greek philosophers. Thales of Miletus was known to trade olive oil via derivatives contracts back in 600 CE. Since then, how derivatives work has changed. 

Types of Derivatives in Trading

“Derivative” is a broad term that’s used to describe an asset class that derives its value from an underlying asset. Broadly speaking, derivatives can be categorised into five types:

• Futures
• Options
• Forwards
• Swaps
• Warrants 

Throughout the next few paragraphs, you’ll notice that some derivatives share similar characteristics while others are unique. We’ll start with futures contracts, one of the most common derivatives on the market.  

1. Futures

A futures contract or simply “futures” is a derivative contract that gives the holder the right and obligation to buy or sell an underlying asset for a pre-agreed price at a predetermined date. 

The price of a futures contract rises and falls based on the underlying asset’s price. But it may not be exactly the same as the market price of the underlying asset. 

2. Options

An options contract or simply “options” is a derivative contract that gives the holder the option to buy or sell an underlying asset at a pre-agreed price and predetermined date. 

Unlike futures, options are not an obligation but a right to buy or sell an underlying asset. Options carry a premium price and can be of two types:

• American: the option can be exercised on or before the expiration date
• European: the option can be exercised only on the expiration date

SEBI only allows European-style options trading in India. 

3. Forwards

Forward contracts or simply “forwards” are more or less similar to futures contracts with a major difference – they’re traded Over the Counter (OTC), meaning forward contracts can’t be traded on a centralised exchange.

While futures contracts are considered to be risky, forward contracts are riskier as they carry a higher degree of risk. More specifically, counterparty risk which means one party may fail to keep up the obligation. 

4. Swaps

Swap contracts or simply “Swaps” are derivatives in which two parties agree to exchange or swap one cash flow for another. For example, swapping payments on a fixed interest loan with a floating interest loan or vice versa.

5. Warrants

Warrant contracts or simply “Warrants” are derivatives similar to options. They give the party the right but not the obligation to buy or sell an underlying asset. 

However, warrants differ from options as they are written by the issuing company, not a third party, and are traded OTC. When someone exercises a warrant, they get freshly issued securities and not existing securities.  

How Do Derivatives Work?

So far, we’ve broken down the basic definition of a derivative contract and the types of derivatives available for trading. Now it’s time to break down the inner workings of a derivative, starting with its components. 

1. Components of a Derivative Contract

We’ve established that a derivative contract derives its value from underlying assets. The thing is, a derivative contract can comprise of:

• A single asset (shares of one company, futures of one commodity, options of a currency pair)
• Multiple financial instruments (options of bullion, futures of metals)
• An index (Nifty 50, Nifty Bank, Finnifty)

The other component of a derivative is lot size, which is the total number of securities included in a contract. Thus, the price of a derivative contract is equal to the lot size multiplied by the price of underlying assets.

Every derivative contract comes with an expiry date on or before which a trader must close their position either by: 

• Fulfilling the terms of the contract 
• Letting the contract expire (worthless) 

2. Where Derivative Contracts are Traded

Derivatives are commonly traded on centralised exchanges via a stockbroker. However, they can be bought and sold Over The Counter (OTC) between two parties as well. 

OTC is known to be flexible but significantly riskier. The reason is simple – the underlying security of a derivatives contract that’s traded OTC is often unregulated and struggles with liquidity as well as higher volatility.  

3. Cost of Trading a Derivative Contract

Derivatives are, by design, relatively costlier than investing in individual securities due to the lot size of every contract. First off, a trader must pay a premium to secure a derivatives contract. 

Next, if the price of the underlying asset moves unfavourably, then the trader may be stuck with an underperforming asset as a result of the obligation of a derivatives contract like commodity futures.  

That said, trading derivatives may be relatively less costly compared to investing in certain instances. For example, an options trader may not necessarily take delivery of the underlying asset. 

4. Nature of a Derivative Contract

You must’ve figured out by now that most derivative contracts deal in the future price of an asset. That’s why they’re known as speculative assets suitable for advanced traders. 

In fact, SEBI has introduced measures to ensure that only those with either a high-risk appetite or access to large capital can trade in derivatives. They’ve done this by establishing an F&O lot size for every financial instrument. 

5. Why Trade Derivative Contracts? 

Companies and traders turn to derivatives contracts for various reasons. A derivative contract offers a hedge for companies looking to lock in the price of a commodity. This also gives the seller a price assurance for their commodity. 

Traders, on the other hand, may buy and sell derivatives to generate profits. At times, they may not even want to take delivery of the underlying asset. Broadly speaking, most derivatives contracts are traded for short-term gains.

Example of Derivative Contracts

Let’s say there’s a company that requires cotton to manufacture clothes. The current price of the commodity is Rs. 44,000 and is expected to rise as high as Rs. 50,000 in the future. This can be unfavourable for the company. 

At the same time, a seller who wishes to sell cotton sees the scenario differently. They see the cotton price rising to Rs. 50,000 and falling to as low as Rs. 43,000. 

That’s why entering into a futures contract at a price locked at say Rs. 46,000 makes sense for both parties. In this scenario, a derivatives contract allows both parties to hedge against unfavourable price movements. 

Bear in mind that companies typically do not enter into derivative contracts for speculative purposes. Traders do that as they look to profit off the price difference between the current and future price of an asset. 

How to Start Trading Derivatives?

You’ll need to open a trading account to buy and sell derivatives in India. To do this, you can choose a recognized stockbroker with a solid track record. Most traders look for existing reviews and check brokerage fees.

Furthermore, you’ll need to evaluate whether the broker gives you access to modern features that can improve your trading experience. For example, the Options Trader App by Dhan gives you access to lightning-fast features like:

• Pre-built Strategies
• Live Market Scan
• Advanced Option Chain
• Pay-off Graphs
• TradingView Charts

Bear in mind that trading derivatives may require access to a significantly large amount of capital. That’s why it’s useful to check whether the broker offers margin trading facilities for derivatives. 

Finally, it’s important to acknowledge that derivatives trading is risky and requires a nuanced approach which takes time, effort, and a significant understanding of the markets. 

Happy trading!

Find out why this feature is super useful for derivatives trading.

Disclaimer: This blog is not to be construed as investment advice. Trading and investing in the securities market carries risk. Please do your own due diligence or consult a trained financial professional before investing.