What is Derivative Trading and why are the numbers high – All you need to know before Derivative Trading

Here are some numbers to start today's article: The derivative volumes are 400X over cash equity. Also, the count of active derivative traders has increased multifold - the total was 0.5 million in 2019 and has jumped to 4 million in 2023 (an eight-fold jump). What are the reasons for these numbers? We will give the reasons for the same in this article. However, before that, we need to understand derivative trading.

What is derivative trading?

Derivative trading involves the buying and selling of financial instruments whose value is derived from the value of an underlying asset, index, rate, or commodity. These financial instruments, known as derivatives, derive their value from the performance of an underlying entity. Derivatives can be used for hedging, speculation, or portfolio diversification. Here are two types of derivatives to know:

Futures Contracts: Futures contracts obligate the buyer to purchase, or the seller to sell, an asset at a predetermined future date and price. Equity contracts, for example, are standardized and traded on stock exchanges.
Options: Options provide the buyer with the right (but not the obligation) to buy or sell an asset at a predetermined price within a specified time frame. The buyer needs to pay a premium for this right. There are two option categories: call options (the right to buy) and put options (the right to sell).

Why can derivative trading be risky?

Derivative trading is considered risky for several reasons, primarily due to the inherent characteristics of derivative instruments and the specific features that distinguish them from traditional investments. Here are some key reasons why derivative trading is considered risky:

Leverage: Derivatives involve leverage, which allows you to control a larger position with a relatively small capital amount. While leverage can boost your profits, it can also increases losses. A small adverse movement in the underlying asset's price can result in significant losses.
Price Volatility: Derivative prices are highly sensitive to changes in the underlying asset value. The inherent volatility in financial markets can lead to rapid and unpredictable price movements, exposing you to the risk of sudden and substantial losses.
Market Risk: Derivatives are subject to market risk, which includes factors such as economic conditions, geopolitical events, and overall market sentiment. External events can impact the value of the underlying assets and, consequently, the value of derivatives.
Complexity: Derivative instruments can be complex, with intricate features and multiple variables affecting their pricing. The complexity can make it challenging for you to fully understand the instruments and the risks involved, increasing the likelihood of errors in trading decisions.
Expiry and Time Decay: Derivatives, such as options, have a finite lifespan and expiration date. As the expiration date approaches, the time value of the option may decrease rapidly, leading to potential losses for the option holder. Time decay is a factor that traders need to consider when dealing with options.

Things to consider while doing derivative trading

Before engaging in derivative trading, you should be well-informed about the market, understand the instruments, and be aware of the associated risks. In addition to the risk part that we have already covered in the previous section, let us look at other parameters to consider:

Understand the underlying asset on which the derivative contracts are based. It could be stocks, indices, commodities, or currency pairs. Knowledge of the specific market and factors influencing the underlying asset is crucial.
Derivative contracts have expiration dates. Futures contracts expire on a specified date, while options have expiration dates. You should be aware of these dates and consider the impact of time decay, especially for options.
In options trading, the strike price is the price at which the option holder can buy or sell the underlying asset. Choose strike prices based on market expectations and your trading strategy.
Each derivative contract has a market lot size, indicating the minimum quantity that can be traded. You must know lot sizes as they determine the contract size and margin requirements.
Derivative trading involves margin requirements, which represent the amount of capital that you must maintain in your trading accounts. Understand initial and maintenance margins and be prepared to meet margin calls.

Why is derivative trading increasing?

Here are a few reasons why derivative trading is increasing in India:

Reason 1: Equity market performance

The benchmark index NIFTY50 has crossed 20,000 levels twice this year, and at present, it is near the 21,000 mark. In 2023, Nifty50 has given over 12% returns and nearly doubled in the last 5 years. The positive momentum in the equity market has increased derivatives trading activity.

Reason 2: FII inflows

Strong FII inflows has also supported the market's bullish momentum. Investor sentiments have been fairly impacted by the decreasing current account deficit.

Reason 3: Increasing participation by retail investors

Retail investors' participation has increased in the stock market, and it has contributed to the surge in derivatives trading activity.

Before you go

As per market experts, the increase in derivative trading is excellent for the Indian stock market. However, for investors, before they start with derivative trading, they must be well-equipped. The most important thing is to have a well-defined risk management system. Also, derivative trading requires careful consideration, and you should be prepared to adapt your strategies based on changing market conditions.