What are Derivatives and How Do you Trade?

Imagine you are an enthusiastic traveller planning a dream vacation. You have spotted a discounted flight but are unsure whether to book now or wait for prices to drop further. You wish you could lock in the current price without committing fully. This is quite similar to derivative trading. Derivatives allow traders to secure the price of an asset today for a transaction that will occur in the future. Let’s dive deeper into derivatives, their significance, and various trading strategies to help you capitalise on price movements effectively.

What Are Derivatives?

Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, or even currencies. These contracts allow two parties to agree on a future price of the asset, either to hedge risks or speculate on price fluctuations. 

The fundamental principle behind derivatives trading is that it helps manage financial risk while offering opportunities to profit from market volatility, including commodities trading.

To explain the derivatives market better, let’s consider an everyday example.

Imagine you are a chocolate manufacturer. You source cocoa beans, and their price is volatile, often fluctuating based on weather conditions and global demand. Fearing a potential rise in cocoa prices, you decide to lock in the current price by entering a futures contract with a supplier. This ensures you can purchase cocoa beans at the agreed-upon price, regardless of future market changes. This contract is a derivative because its value hinges on the cost of cocoa beans, and you have hedged your risk against a price increase.You could use a trading app to track cocoa prices and manage your derivatives contracts.

Types of Derivatives and Their Functionality

There are various forms of derivatives, each with distinct features. Let’s explore the key types of contracts used in derivative trading:

How to Trade Derivatives: Effective Strategies

Successful derivative trading requires the application of appropriate strategies. Below are some popular techniques to help you navigate equity derivatives, currency derivatives, and other market derivatives:

Calendar Spread

A calendar spread is a strategy where you simultaneously buy and sell options of the same underlying asset but with different expiry dates. This approach profits from the time decay of the shorter-term option.

For instance, suppose you expect a stock price to remain stable for the next month but anticipate significant movement thereafter. You could sell a short-term option (expiring in one month) and buy a longer-term option (expiring in two months) on the same stock, benefiting from the shorter-term option’s time decay.

Covered Call

A covered call involves holding a long position in an asset while selling a call option on the same asset. This strategy generates income through premiums while still benefiting from the potential price appreciation of the asset.

For example, if you own 100 shares of ABC Ltd. at ₹500 each, you can sell a call option with a strike price of ₹550. If the stock stays below ₹550, you keep the premium. If it rises above ₹550, your shares get sold, but you still earn the premium plus the price appreciation.

Iron Condor

The Iron Condor strategy is popular in derivatives trading and is used when a trader expects low volatility in the market. This involves selling an out-of-the-money call and put while simultaneously buying a further out-of-the-money call and put to cap potential losses.

Suppose a stock is trading at ₹200. You might sell a ₹210 call and a ₹190 put while buying a ₹220 call and a ₹180 put. If the stock stays between ₹190 and ₹210 by expiry, you profit from the premiums of both the short positions.

Protective Collar

A protective collar is a conservative strategy combining a long position with a put option and a short call option. It is typically used to protect against significant losses while still allowing some upside potential.

For instance, if you own shares of XYZ Ltd. and are worried about a potential drop in price, you could purchase a put option with a lower strike price and simultaneously sell a call option with a higher strike price. This limits your downside risk while collecting premiums from selling the call.

Ratio Spread

A ratio spread is an advanced derivatives market strategy where you buy a certain number of options and sell a higher number of the same type of options with different strike prices.

For example, you could buy one call option at ₹100 and sell two call options at ₹120. This strategy allows you to profit if the asset’s price moves towards ₹120, but if the price exceeds ₹120, your profit potential is capped, and losses could occur if the price continues to rise.

Strangle

A strangle is a strategy where a trader buys both a call and a put option with different strike prices but the same expiration. This approach profits from significant price movement in either direction.

If you anticipate large volatility in the price of a stock but are uncertain about the direction, you might purchase a call option at ₹150 and a put option at ₹130. A substantial move in either direction allows you to profit from one of the options while the other expires worthless.

Why Use Derivatives?

The derivatives market provides several benefits, making it a vital part of modern financial systems:

• Hedging: One of the most significant uses of market derivatives is to hedge against risks in the underlying asset. For example, an importer can use currency derivatives to protect against fluctuations in exchange rates.
• Speculation: Traders use share market derivatives to speculate on price movements. They can profit from either rising or falling markets without directly owning the underlying asset.
• Leverage: A small investment can control a large position with derivative trading due to the leverage involved. This magnifies both potential gains and losses.
• Access to Different Markets: Through derivatives, traders can access a wide range of markets, including equities, commodities, and foreign currencies, giving them more opportunities for diversification.

Key Considerations Before Trading Derivatives

While the potential rewards of derivatives trading are appealing, it’s essential to consider the risks involved. Below are some tips for minimising risk and maximising success:

• Educate Yourself: Start by learning the derivative’s meaning. This knowledge will help you make informed decisions.
• Risk Management: Use stop-loss orders and limit your exposure to leverage to protect against large losses.
• Choose the Right Platform: When starting, opt for a trusted app, such as the HDFC Sky App, which offers real-time data, easy-to-use trading tools, and educational resources to help guide your decisions.”
• Stay Updated: The financial market is influenced by economic events, so stay updated on news that may affect asset prices.

Conclusion

Trading derivatives can effectively manage risk and take advantage of price fluctuations in the financial markets. Applying the right strategy is crucial whether you use equity or currency derivatives. Always approach the market with a clear plan, mindful risk management, and a trusted trading platform.

Start your journey into derivatives trading today by Opening Demat Account Online and confidently exploring the financial market’s possibilities.