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Derivative trading involves buying and selling financial contracts whose value is derived from an underlying asset or benchmark. The underlying can include stocks, indices, commodities, currencies, interest rates, or other financial instruments.
Unlike buying an asset directly, derivative traders enter contracts based on the expected future movement of its price.
This article will tell you how derivative contracts function.
Key Takeaways
- Derivative contracts trade on recognised stock exchanges or over-the-counter (OTC) and have a fixed expiry date.
- Futures obligate both parties to execute the trade on a set date, whereas options give the buyer a right, not an obligation.
- Leverage lets traders control large market positions by depositing only a fraction of the total contract value as margin.
- Profits and losses from Futures and Options (F&O) trading are classified as non-speculative business income under Indian tax laws.
- Recent regulatory updates include enhanced Securities Transaction Tax (STT) rates and stricter 50:50 cash-to-non-cash margin structures.
What is Derivatives Trading?
Derivatives trading involves entering into agreements to buy or sell an asset at a predetermined future date. Unlike cash market transactions, traders do not immediately acquire ownership of the underlying security when they execute a trade. Instead, they trade contracts tracking price movements.
Key components of a derivative contract include:
- Underlying Asset: The reference instrument, such as an individual stock, stock index, commodity, or currency.
- Contract / Lot Size: The standardised quantity of the underlying asset defined by the exchange per contract.
- Expiry Date: The final date on which the contract settles or expires.
- Settlement Mechanism: Contracts settle via physical delivery (mandatory for Indian stock derivatives) or cash settlement (mandatory for index derivatives).
- Positions: Traders take a long position expecting prices to rise, or a short position expecting prices to fall.
Types of Derivative Contracts
- Futures: Standardised contracts traded on exchanges where both buyer and seller are legally obligated to execute the transaction at a predetermined price on expiry.
- Options: Contracts giving the buyer the right, but not the obligation, to buy (Call Option) or sell (Put Option) the asset at a specified strike price. The seller (writer) must fulfil the contract if exercised.
- Forwards: Customised bilateral contracts traded over-the-counter (OTC) between two parties without exchange intervention.
- Swaps: Private, customised agreements to exchange cash flows over future periods based on specific financial formulas.
Futures vs Options: Key Differences
|
Feature |
Futures |
Options |
|
Obligation |
Mandatory for both buyer and seller. |
The buyer has a right. The seller has an obligation. |
|
Upfront Cost |
Margin deposit required. No initial premium. |
Option: buyer pays a non-refundable premium upfront. |
|
Risk Profile |
Unlimited loss potential for both long and short positions. |
Limited loss (premium paid) for buyers. High/unlimited risk for sellers. |
|
Flexibility |
Highly standardised exchange contracts. |
Customisable strike prices and expiries. |
Participants in the Derivatives Market
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Hedgers: Producers, manufacturers, and institutional investors who use derivatives to neutralise adverse price fluctuation risks.
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Speculators: Traders seeking to profit from short-term price movements without intending to take delivery of the asset.
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Arbitrageurs: Traders exploiting temporary price inefficiencies for the same asset across different markets or segments.
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Margin Traders: Participants utilising broker-provided leverage facilities to scale up trade sizes.
How to Start Derivatives Trading
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Account Setup: Open a linked trading and Demat account with a SEBI-registered broker and activate the F&O segment by submitting required income proofs. Ensure Demat nomination compliance is up to date.
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Research and Selection: Analyse market trends, check contract liquidity, and evaluate lot sizes against available capital.
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Margin Funding: Deposit the mandatory initial margin (incorporating the 50:50 cash and non-cash collateral mandate) into your trading account.
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Execution and Management: Place your order on the exchange terminal. Monitor open positions continuously to avoid margin shortfalls and potential square-offs.
Advantages and Risks of Derivatives
Advantages
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Efficient Hedging: Mitigates portfolio downside risks against volatile market shifts.
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High Liquidity: Exchange-traded derivatives offer deep liquidity, allowing smooth entry and exit.
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Capital Efficiency: Leverage lets you control high-value positions with less initial capital.
Risks
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Leverage Amplification: Leverage magnifies gains, but it equally multiplies potential losses.
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Time Decay (Theta): Option buyers face asset value erosion over time as expiration approaches.
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Counterparty Risk: Primarily a concern in OTC derivative instruments like forwards and swaps.
Regulations, Taxes, and Charges in India
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Tax Treatment: F&O trading profits are classified as non-speculative business income, taxed according to your applicable income tax slab. You can write off business expenses, and you can carry forward net business losses for up to 8 years.
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Securities Transaction Tax (STT): STT stands at 0.05% on futures turnover and 0.15% on option premiums.
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Margin Structure: SEBI mandates a strict 50:50 margin framework, requiring at least 50% of the total margin requirement to be maintained in cash or cash equivalents.
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Other Levies: Stamp duty (0.002% for futures, 0.003% for options), GST (18% on brokerage and exchange fees), and SEBI turnover fees apply.
Conclusion
Derivatives trading remains a popular trading option, enabling participants to manage risks. Leverage can amplify losses as well as gains. They are also subject to levies and charges such as STT, which can reduce investors' gains.
Understanding derivatives helps investors make informed market decisions about instruments such as F&O, options, and more.
