Derivatives are often mentioned when people talk about trading or market risk. Many retail investors think of them as complicated financial instruments meant only for professionals. In reality, derivatives are simply contracts. They exist to deal with price movement and uncertainty. In stock markets today, derivatives play a major role. They influence volumes, pricing and even sentiment.
What is a Derivative?
A derivative is a financial agreement between two parties. Its value comes from another asset. This asset may be a stock an index, or something else. The derivative itself has no independent value. It reacts to the price of the underlying asset. If the underlying asset moves, the derivative moves with it. For example, a contract based on a stock, tracks how the underlying stock price behaves.
Why Markets Use Derivatives
Markets are uncertain by nature. Prices change daily. Sometimes they change suddenly. Derivatives are created to handle this uncertainty.
Originally, derivatives helped participants fix prices in advance. This made planning easier. Over time, their role expanded. Today they help investors express views, manage exposure and shift risk rather than remove it.
Derivatives also help markets understand expectations. When many participants trade contracts linked to future prices, those trades reflect collective thinking. This thinking influences how prices behave today.
Types of Derivatives
Several types of derivatives are used in the stock market. Each has a purpose.
Futures
Futures are contracts to buy or sell an asset at a fixed price on a future date. These contracts are traded on exchanges. The terms are standardized.
In equity markets, futures are mostly based on indices or stocks. Investors use them to take exposure without paying the full value upfront. Futures react strongly to price movement. This makes them efficient but demanding. Because futures are exchange traded, clearing corporations stand in between buyers and sellers. This reduces counterparty risk. It also increases trust in the system.
Options
Options work differently. A call option gives the right to buy. A put option gives the right to sell. To buy an option, a premium is paid. This premium is the maximum possible loss for the buyer. If the market moves favorably, the option gains value. If it does not, the option expires.
Options are often used for protection. They are also used for directional strategies. Many investors prefer them because risk is defined from the start.
Forwards
Forward contracts are private agreements. They are similar to futures but are not traded on exchanges. The terms are flexible and decided by both parties. This flexibility also brings risk. If one party fails to meet the obligation, losses may occur. Because of this, forwards are mostly used by institutions.
Swaps
Swaps involve exchanging financial obligations. These are usually linked to interest rates or currencies. Swaps are not common for retail equity investors but remain important in overall financial markets.
Who Trades Derivatives
Different participants use derivatives for different reasons.
- Hedgers use them to reduce risk. They already hold exposure and want stability. Their goal is not profit from movement.
- Speculators seek price movement. They use derivatives to benefit from rising or falling markets. Capital required is lower, but risk is higher.
- Arbitrageurs look for price differences. They move quickly and operate on small margins. Their trades help align prices across markets.
- Institutions use derivatives to manage large portfolios. They adjust exposure without changing core holdings. This allows smoother portfolio control.
Why Derivatives Matter
Derivatives help manage risk. This is their primary function.
- They improve liquidity. Active trading allows smoother entry and exit.
- They support price discovery. Market expectations become visible through derivative pricing.
- They allow flexible participation. Exposure becomes possible without direct ownership.
- When used correctly, derivatives support market efficiency.
Risks
Derivatives carry clear and significant risk. Leverage magnifies outcomes, so even small price changes can lead to large gains or losses. This can have adverse impact on investors with less risk appetite or low capital
Derivatives in the Indian Market
India has an active derivatives market. Futures and Options form a large share of daily volumes, index derivatives being the most popular. The market is regulated by SEBI.Rules around margins, position limits and taxation are updated regularly to reduce speculation.
Recent regulatory actions have increased transaction costs to encourage more thoughtful market participation.
