Common Financial Terms & Concepts

What are Derivatives? Definition, Meaning and Types

We all are looking for ways to earn higher with lower risk. Our trading system has evolved so much and there are soo many new financial instruments which can help us reach our goals. That brings us to this interesting financial term “Derivative trading”.

What are Derivatives? Meaning

Derivative is a contract between two parties that derives its value from the performance of an underlying asset.

Simply speaking, these are financial contracts wherein both the parties agree to exchange an underlying asset or group of assets at a fixed price on a fixed and pre-determined date. That simply means it's an agreement wherein Mr.A agrees to buy a barrel of oil at 40$ on 10th October 2020 from Mr.B.

Types of Derivatives

The below are the different types of derivatives:

1. Future Contracts

  • A future is a contract wherein the individual trader has a right as well as an obligation to buy or sell an underlying stock (or other asset) at a predetermined price and time.

-  There is no payment required until the stipulated date.

- Both “buyer” and “seller” have a mandatory obligation to comply with the terms of an agreement.

- The risk factor is higher as the individual has no other way other than complying with the agreed contract. Thus the seller has no restriction or upper limits set for profit or loss.

- In the above example, Mr. A has to buy at  40$ even if the price on 10th October 2020 is 30$ and Mr.B has to sell the same at 40$. In this scenario it’s a gain for Mr.B and loss for Mr.A.

2. Forward Contracts

-  Similar to futures contract, a forward is a contract wherein the individual agrees to buy or sell an underlying stock (or other asset) at a predetermined price and time. But the only difference in between the two is that futures are traded in an open market and are regulated as per government norms, whereas forward contracts are traded in private and there is no authority to enforce the financial transcation.

-  These contracts are customizable to suit the needs and requirements of the parties to the contract. Thus it gives higher flexibility (but at higher risk) to both the parties to design the clause and point of negotiations.

-  The risks are higher as there is no guarantee of asset settlement until the day of such contract maturity.

3. Option Contracts:

-  Options are contracts wherein the individual trader has a right but not an obligation to buy or sell an underlying asset or stock. A “call” option is the right to buy a fixed stock or the commodity at a fixed price and on or before a pre-determined time, while a “put” option is a right to sell a fixed asset at a fixed price on or before the expiry of such an agreement.

-  The buyer has to pay a fixed amount of premium (which is paid in advance) to enter such a contract.

-  If the buyer decides to invoke the terms of the contract, then the seller has the obligation to comply with the same. Thus the power in such an option contract lies with the buyer.

- This option is less risky as the scope of the loss is restricted to the premium paid as the individuals have the choice not to adhere to the contract.

- In the above example let’s assume the price of a barrel was 30$. In this case under option contract Mr. A can deny to comply with the contract thus Mr. A would lose the premium value paid to enter such contract.

4. Swap Contracts

- It’s an agreement between the two parties to exchange underlying assets at the given date and time set at a future date. The most common instrument traded under these types of contracts is currency, interest, equity shares, commodity trading, etc.

- Like forwards, a swap is also customizable agreements which are agreed in between parties after negotiation over-the-counter (OTC) i.e. privately instead of trading in an open market.

- The profit and loss are calculated as per market trends thus there is no restriction or upper limits set on either sides.

- Taking the same example, under such an agreement, Mr. A agrees to buy 1 barrel against 1 meter of silk on 10th October 2020. On the said date the price of silk can be higher than the barrel or vice versa. Thus, the parties have to do the exchange on the said day.

With the underlying rules remaining the same the above are the different types of derivatives which are traded in the market. Each comes with its own unique points, requirements and risks. Thus, an individual can choose and match the criteria with their own requirement and start trading into derivatives but with extreme caution.

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