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Types of Derivatives

Derivative contracts can broken down into the following four types:

Options

Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period of time.

Option contracts consist of two options:

Call Option

In call option, the buyer has all the right to purchase an underlying asset at a fixed price while entering the contracts.

Put Option

In put option, the buyer has all the right but not obligation to sell an underlying asset at a fixed price while entering the contract.

However, in both call and put option contracts, the buyer chooses to settle all the contracts on or before the expiry period.

Futures

Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date. The parties involved in a futures contract not only possess the right but also are under the obligation to carry out the contract as agreed. 

Futures contracts are traded on the exchange market and as such, they tend to be highly liquid, intermediated and regulated by the exchange. 

Forwards

Forward contracts mean two parties come together and enter into an agreement to buy and sell an underlying asset set at a fixed date and agreed on a price in the future.

In simpler words, it is an agreement formed between both parties to sell their asset on an agreed future date.

The forward contracts are customized and have a high tendency of counterparty risk. Counterparty risk is a type of credit risk in which the buyer or seller may be unable to fulfill his or her obligations. If a buyer or seller goes bankrupt and is unable to fulfill his or her obligations, the other party may be without remedy to salvage his or her position

Swaps

Swaps, as the name implies, are exactly what they sound like. Swaps are a type of financial derivative used to convert one type of cash flow into another. Swaps are private agreements between parties that are primarily exchanged over the counter and are not traded on exchanges.

Currency swaps and interest rate swaps are the two most popular types of swaps. An interest rate swap, for example, can be used to convert a variable interest loan to a fixed interest loan or vice versa.

Benefits of Derivatives Trading

Derivatives offer numerous advantages to the financial markets. Let’s look at the benefits of derivatives:

Exposure to Hedging Risk

Since the value of the derivatives is directly linked to the underlying asset’s value, the contracts are mainly used for hedging risks. For instance, an investor may buy a derivative contract whose value moves opposite to the value of an asset the investor owns; this way, profits in the derivative contract may offset losses in the underlying asset.

Lower transaction costs

When compared to other securities such as stocks or bonds, trading in the derivatives markets has a low transaction cost. As derivatives are primarily used to control risk, they ensure lower transaction costs.

Identifying the price of the underlying asset

Derivatives help in identifying the price valuation of the underlying asset.

High leverage

 In general, leverage is defined as borrowing funds to make investments. In derivatives, one of the benefits is that it provides high leverage i.e. the capital needed for taking positions in derivative instruments is generally much less than capital needed to actually take the positions in stock markets. In case of Futures, only 20%-40% of the total contract value is required to start trading, whereas, in Options, only the premium amount is required to trade

Transfer of Risk

In derivatives, risk can be transferred from one party to another party who is willing to bear it.

What are Exchange-Traded Derivatives?

Exchange-traded derivatives (ETD) consist mostly of options and futures traded on public exchanges, with a standardized contract. Through the contracts, the exchange determines an expiration date, settlement process, and lot size, and specifically states the underlying instruments on which the derivatives can be created.

Hence, exchange-traded derivatives promote transparency and liquidity by providing market-based pricing information.

Types of exchange-traded derivatives

Stock or equity derivatives: Common stock is the most commonly traded asset class used in exchange-traded derivatives.

As exchange-traded derivatives tend to be standardized, not only does that improve the liquidity of the contract, but also means that there are many different expiries and strike prices to choose from.

Index derivatives: Not only are you able to transact derivatives in single-name stocks, but you can also trade derivatives tied to the performance of a stock index or basket of stocks.

Index-related derivatives are sold to investors that would like to buy or sell an entire exchange instead of simply futures of a particular stock.

Currency derivatives: Exchange-traded derivatives markets list a common currency pair for trading. Futures contracts or options are available for the pairs, and investors can choose to go long or short.

Commodities derivatives: Derivatives trading in commodities includes futures and options that are linked to physical assets or commodities. Most commonly, we see trading in oil and gas futures, agricultural and metals.

These are very important not only for the producers of commodities, such as oil companies, farmers and miners, but also a way that downstream industries that rely on the supply of these commodities hedge their costs.

Interest rate derivatives: Another family of commonly traded ETDs are those related to fixed income products, such as government bond futures. These bond futures give fixed income traders an efficient and effective way to manage their interest risk exposure.

How do Trade Derivatives?

Step 1: Before you can start trading in various types of derivatives, you must first open an online trading account. If you’re trading derivatives through a broker, you can take orders over the phone or even online.

Step 2: You must pay a margin amount when you begin trading derivatives and their types, which you cannot withdraw until the contract is completed and the trade is concluded. Suppose your margin goes below the minimum permissible amount while trading; you will receive a margin call to rebalance it.

Step 3: Make sure you know everything there is to know about the underlying asset. Keep your budget in mind and make sure it’s sufficient for fulfilling the financial requirements of the margin for trading, cash on hand, and contract prices.

Step 4: You should keep your investment in the contract until the trade is resolved.
 

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