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What are derivatives

Derivatives are the financial instruments that derive their value from an underlying asset. This defition tries to explain a gaint topic in single line and thats why, it looks little bit confusing.So, here is the explanation of derivatives in very simple words :
My dear friends, derivatives are nothing but contracts between two or more parties for a trade which haven't taken place yet.Two or more parties including both buyers and seller of a particular item agree to place the trade ( buying and selling of item internally between the parties signing the contract) after some time at a fixed price which is decided at the time of signing the contract. The item on which this contract is signed is called underlying asset.This underlying asset can be any physical commodity like gold, silver, wheat or it can be an abstract item like stocks, currencies and "price indexes".
In the above paragraph, we just read that derivatives are contracts of the trades which are going to be performed in the future. These are the contracts of the trades which have not taken place and will be accomplished after some time.Here, the question arises on the use of derivatives because after some time, when the buying and selling will be done, rates of the commodities may be different. Either the prices increase or they decrease, one party will have to face loss. How?
See, when they sign the contract, they agree to buy and sell the item they have fixed in the contract. Now suppose that the pprice of the commodity increase, then also the seller will have to sell the commodity at the fixed price decided before handedly and thus he face some loss as compared to other sellerss.Similar case applies to buyers when the price of that commodity decrease but they will have to buy it at previously fixed price.
So , why do we use derivatives when there is an uncertainity in the market prices? Let us discuss and try to understand it with the help of an example. But this topic is a mess in itself, so watch this video to get an overview of the topic so that you understand each and every point with ease.

Why do we use derivatives ?

So the question is that why do we use derivatives when there is an uncertainity in the market prices? But the irony is that we use derivatives because their is an uncertainity in the market. Let us understand.
Suppose there is a farmer named Dhania who have sown potatoes in his fields. Can you imagine the condition of Dhania here? He is facing too many uncertainities. He does not know whether the natural factors like temperature,rainfall or humidity will be in his favour or not. Even if everything goes well, he does not have any guarantee that he will get an appropriate amount of money on selling potatoes. If the production of potatoes reach a record level high and it surpass it's demand level, prices of potatoes will drastically decrease. This will led Mr.Dhania to a good amount of loss. On a safer side, Dhania wants to sell his potatoes at a minimum ofRs. 5 per Kg.
Dhania-hardik best example of derivatives
In the nearby city, Mr.Hardik owns a chips making factory. His factory needs potato as a raw material for making chips . Mr Hardik too have a concern related to potato prices but unlike Dhania, he does not want the prices of potatoes to increase after they are ready to sell in the market. Therefore Mr Hardik visits Mr.Dhania and purposes a deal to him. He says to Dhania," Let us make a deal . What ever the price of potatoes after 2 months be, I will buy them from you at the price of Rs.5 per Kg even if the the market price of potatoes reach Rs.4 per Kg. But the condition is, that you will too have to sell me the potatoes at Rs. 5 even if the market price of potatoes reach Rs. 7 per kg". At first, Dhania thinks and then agrees on the contract .
This way,Mr.Hardik and Mr.Dhania reduce the risk of facing loss.But both of the reduce their chance of earning more profit because if the price of potato reach Rs.7, Dhania will have to sell them at Rs. 5 to Hardik.Here comes the point that what if Mr. Dhania refuse sell the potatoes to Mr.Hardik if he get Rs.7 per kg? For this, there are different types of Derivatives which you should definitely read so that you get the answer of this question.
In the example above, we only came to the point that derivatives are used to reduce the risk but it is not totally true.There are many different types of tradersinvolved in derivatives trading with different ambitions. We will study study all these goals for which people invest in derivatives, but first, we need to study the features of Derivatives to move further any more.

Features of the Derivatives

(i) They have an expiry date

As we have all read that derivatives are the trade contracts that are going to be accomplished after some time. But we can not simply say it as after sometime, we put a condition of time on it like after 2 months,3 months, we will engage in the trade. Engaging in the trade means the item on which this contract has been signed will be delivered to the buyer. Therefore, after 2 or 3 months, this derivative will have no use because contracts were only to get that item out only.

(ii) Margin Trading available

Let me first explain the meaning of Margin trading to the ones who don't know. Margin trading, also known as leverage trading is a type of trading in which the investor borrows the money from his broker to invest and that too without any rate of interest. What do the broker have benefit here?
When you trade by buying extra cash , you will have to pay the extra brokerage which will become the income of the broker . The money that you have borrowed from the broker will obviously demanded back by the broker and you will return back after some time. In normal equity trading, you can get leverage only for intraday trading. If you want to trade for some longer time, you can not take the margin.
So, if you want to trade with margin, you can do this by trading derivatives as you can easily get the margin for investing in derivatives. So, this is also a great feature of derivatives.

(iii) Both Short & Long trades available

Long position trading : It is a normal investment where you buy the commodity first and sell it later. Investor aims to buy it lower rate and than sell it higher prices to make some profit. This type of trading is useful when market is in upward trend.
Short position trading :In this position, you sell first at higher price and than buy it back at lower price to book the profits. This type of trading is useful when market is in downward trend.
Like leverage trading, short position are also available only in the intraday market . If you want to enter a long term short position , you can invest in the derivatives.

(v) Buy only in Lots

When you trade in Derivatives (F&O) , you can not trade simply in 1,2 or 3 stocks. You have to buy the lots of these stocks.Now,what do lots mean ? Lots are the group of shares of the same company. Each company have a fixed lot size (minimum number of stocks that can be traded in future ).
As in our case,if we want to buy the derivatives of ONGC company,we will have to buy the whole lot size which in this case is 7700.So the minimum number of stocks in which we can invest is 7700 here. Lot size may vary from company to company ,which is decided by the stock exchange time to time depending on the price of the shares of a given company. If you want to check out the present lot sizes, you can do so by cicking here.

(iv) Have it's own monetary value

If you didn't knew this prior, you will be surprised to read that Derivatives are just trade trade contracts but have their own monetary value. By monetary value, we mean that derivatives have specific money value of themselves for which buying and selling of these contracts can be carried out.What? How can be the contracts assigned for some trade can themselves be traded? Let us understand it with an another example.
Suppose I am very rich person and tech savvy with my own personal choice. One day I saw some computer mouse somewhere with a very unique design. Lateer i got to know that the manufacturing of that mouse is not excercised now. So, as you know that i am very rich, i announce that whosoever have a mouse with same design,i will give him 2 lakh rupee and buy all the mouses in the city(this is only a hypothetical example,don't consider me a fool). When I announce that anybody having a mouse of the particular model, i will pay him 2 lakh rupee and buy the mouse,it means that the person having this particular mouse, he have 2lakh rupees while the real value to buy a mouse is nearly of only 500 . After my announcement, if someone want to sell his mouse, he can sell it to nearly 2 lakh before I step back from my announcement. In similar way, if we have derivatives of stocks, it means that we will get stocks mentioned in those derivatives after a particular time. This means, whosoever will have those contracts, he will have those stocks and thus that money value of stocks. Therefore, we can say that derivatives have got their value similar to stocks. In this way, being merely the trade contracts, derivatives have their own monetary value and because they derive their value from an underlying asset like stocks, they are called derivatives.

Types of traders trading with Derivatives

  1. Hedgers :
  2. Hedging is a strategy to minimizing the losses, but not maximizing the profits.Hedgers are the traders that focus only to minimize the risk on investment like we discussed the example of Mr Dhania and Mr Hardik .
    Thus, Hedging will not help us to make more profits. Hedgers are the people who are attempting to minimize their risk. For example, If we hold shares and we don’t know that the price of these shares might fall in near future, so that we can protect ourselves by selling these Futures. If the market actually will fall in a short run, we will make a loss on the shares, but will make a profit on the Futures. Hence, we will be able to set off our losses with profits. Hedging is a strategy to protect our position if an adverse move in a currency pair.
  3. Speculators:
  4. A speculator is a person or an entity that trades securities (or commodities, bonds, derivatives, etc..) essentially as bet on future price movements of the security and typically has an above average risk tolerance. Speculators can increase the potential gains or potential losses in a speculative market. Speculators take large risks in order to make quick and large gains. If a speculator believes that a particular security or commodity is going to increase in price, the speculator may choose that security to buy as much as possible.This activity can increase demand the security to go up the price which may cause to others also can purchase of that security. Finally, the result will be the price of the security above its true value. Conversely, if a speculator believes that a particular security or commodity is going to decrease in price, the speculator may choose that security to sell as much as possible. This activity can decrease demand the security and thereby the prices of the security will go down which may cause to others also can sell that security. Finally, the result will be the price of the security below its true value.
  5. Margin Traders:
  6. Arbitrageurs:
  7. Arbitrage means the buying and selling of securities, commodities, futures, options or any combination of such products in different markets (i.e. different bench marks such as SENSEX, NIFTY, FTSE, etc..) at the same time to take advantage of any price difference opportunities in such markets. For example, an arbitrageur would seek out the price differences between stocks listed on more than one exchange (bench mark) by buying the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange. Therefore, an arbitrageur can get the risk-free profits as the prices on the two exchanges tend to meet at a point. Arbitrageurs are typically very experienced investors. Briefly, Speculators provide liquidity and volume to the market while hedgers provide the depth. Arbitrageurs assist in proper price discovery and correct price abnormalities. Hedger avoids the risk while speculator takes the risk.

What are all types of Derivatives?


1) Where are derivatives traded ?