What is the Meaning of Derivatives Trading in Stock Market?

01 Sep 2021|

3 min read |

by ICICI Securities Team

Introduction

Derivatives as financial instruments depend upon underlying assets for their value. These instruments have been traded in markets throughout the ages. The history of Derivatives trading has step by step evolved in range and complexity, laying down what would become the foundation of the modern trade in Derivatives that started in the 1970s.

What is Derivative trading?

Derivative trading is the purchase or sale of Derivatives in the share market.
Trading in Derivatives revolves around the agreement between the trading parties to trade Derivatives in future for a predetermined price.
Derivative trading usually happens according to the business hours of the share market.

What are the requirements for Derivatives trading?

While trading in Derivatives is similar to other kinds of trading, there are some requirements that traders must fulfil before they can begin trading in Derivatives:

Traders are required to have an active demat account which is the account that stores securities in digital format.
Traders must have a trading account through which the actual trade is conducted. The trading account is linked to the demat account and acts as the trader's identity in the share market.
Traders must deposit and maintain a fund which is a percentage of the total value of the underlying asset and the calculated price fluctuations. This process is called margin maintenance, and traders must do so daily as per price fluctuations.

Participants of Derivative Trading

Not all traders participate in the trade of Derivatives trading for the same reasons. Based on their goals, traders participating in Derivative trading can be broadly categorised into the following:

Hedgers are risk-averse traders who trade in Derivatives to protect themselves from price fluctuations. They do so by fixing the price of an underlying asset and transferring risk associated with price fluctuations to risk-oriented speculators.
Speculators are risk-oriented traders who take risks from Hedgers to profit from price fluctuations. They form an essential source of liquidity to the share markets.
Arbitrageurs are low-risk traders who attempt to profit by selling the same asset for two different prices in two other markets.

Benefits of Derivative trading

Trading in Derivatives presents different benefits that can meet the needs of various investors:

Trading in Derivatives involves lower transaction costs than in other forms of trading as the Derivatives act as risk management tools.
Derivative trading can be a valuable tool for protection against price fluctuations as such fluctuations are already factored into contracts.
Trading in Derivatives allows investors arbitrage opportunities to gain higher profits through speculations on price differences and fluctuations in different markets.

Drawbacks of Derivative Trading

While trading in Derivatives presents significant benefits to traders, they also have significant drawbacks which must be navigated for a successful trade:

Derivatives are susceptible to price fluctuations, which can lead to severe loss if not managed properly.
Contracts in Derivatives trading are challenging to break before expiration, which leaves traders vulnerable to market uncertainty.
Trading in Derivatives requires extensive knowledge of complex processes of the financial markets, which makes it restrictive.

What is the difference between futures and options contracts?

Futures and options are two commonly known types of derivatives contracts. They derive their value from an underlying security, commodity, or index and the movements these assets make in the market.

However, futures and options contracts are different from one another. When you opt for a futures contract, you are obligated to buy or purchase an asset at a specific future date. On the other hand, when you opt for an options contract, you have the right but are not obligated, to buy or sell a specific asset at any given point during the contract term.

What is "margin money" in derivatives trading?

Margin money in derivatives trading is the minimum amount a trader must deposit with the broker to enter into a derivatives contract. This amount is a specific percentage of the total value of the outstanding position. It acts as collateral and is used to cover any potential losses incurred during the trade.

What are the charges on derivatives contracts?

The charges that you might have to pay upon trading in derivatives contracts are as follows:

Brokerage charges: Your broker will charge you for the services they provide that enable you to trade. The charges will vary as per the brokering house.
Securities Transaction Tax (STT): The STT for futures is charged at 0.01% of the contract’s notional value. When it comes to options, the STT rate is 0.05% of the premium value. In both cases, STT is charged on the sell side, not the buy side.
Exchange transaction charges: These are the charges payable to the stock exchange and are collected by the broker.
Goods and Service Tax: This charge is levied on the brokerage amount and amounts to 18% of the brokerage and transaction charges.
SEBI turnover fee: Charged by SEBI, it amounts to Rs 10 for every crore value of trade transacted.
Stamp Duty: You also have to pay stamp duty as per standardised rates.

Conclusion

Derivative trading represents the more complex segments of financial trade, requiring expert knowledge and skill in gauging probability. While such requirements might deter some investors, others have embraced this particular class of trade, eager to take advantage of its opportunity. The digital nature of such trade makes it likely that it will continue to grow in the future as technology keeps advancing.

Disclaimer