What is Derivatives Meaning & Types of Derivatives?

• Derivatives are financial contracts which derive their value from underlying assets such as stocks, commodities, etc.
• Derivatives allow you to hedge investment risk, enable arbitrage trading, and mitigate market volatility.
• The different types of derivatives in stock market include futures, options, forwards and swaps.

Investing is one of the best ways to grow your wealth and most people prefer to invest in instruments that provide security and guaranteed returns. As you gain more and more experience and knowledge about markets, you tend to move towards riskier options with the objective to grow your investments rapidly. In thi blog, let us learn about the types of derivatives, meaning of derivatives, and the advantages of trading in derivatives in detail.

Derivatives are financial contracts which derive their value from underlying assets like stocks, bonds , currencies, commodities, and market indices. It is an agreement between two or more parties where trading occurs over the counter or via an exchange. In this, the value of the underlying asset fluctuates as per the market conditions.Derivatives in stock market are used to speculate prices by betting on the future value of the underlying asset and subsequently reaping profits. However, a fall in the asset price may also cause you to incur losses.Furthermore, due to the involvement of other parties, a counterparty risk is involved in these types of contracts. Counterparty risk is a credit risk wherein there is a possibility of one of the parties defaulting on the contract. Hence, it is important to read the derivatives contract carefully before agreeing upon the established terms.

Here are the top advantages of derivatives trading:

Hedging

Traders can protect themselves against risky investments via trading in derivative contracts. It enables hedging risk, which refers to reducing risk in your investment by creating a new investment.For instance, when you trade in derivatives in stock market, you bet funds on a certain stock that has the possibility of a rise or fall in price. If the stock price starts falling, you can enter into a derivative contract to predict the reduction in the stock value. You can then reap profits by hedging your stock market losses.

Arbitrage

Derivatives in stock market offer traders the benefit of arbitrage trading. This enables them to make profits from the differences in pricing in different markets.In arbitrage trading, an asset is purchased at a low price in one market and then sold at a higher price in another market.

Mitigate Market Risk

Investing in derivatives protects traders from market volatility and mitigates losses due to market risk. For example, you can buy gold in the commodities market and then enter into a derivatives contract with the same underlying asset. This safeguards your portfolio as either of the investments can hedge your losses against the other. Also Read: What are Financial Derivatives ?

Low Transaction Costs

Trading in derivatives markets involves low transaction cost as compared to trading in other securities, such as stocks or bonds.

The different types of derivatives in stock market are explained below:

Forwards

Forwards are an agreement between two parties to buy or sell an asset at a predetermined price on a future date. These derivatives are traded over-the-counter and not on exchanges.Largely effective for hedging and reducing risk, forwards are also subject to counterparty risk. For example, if either party goes bankrupt and is unable to fulfil his or her obligation, then the other party may not be able to square off his or her position.

Options

Financial derivatives options are contracts in which you have the option to buy or sell a financial asset but not the obligation to do so. Just like forwards, it is also an agreement between involved parties to trade a security at a certain price on a future date.The parties involved in an options contract can sell or buy the security at any time. It is provided to reduce risk in the future if the market is volatile.

Futures

Futures are financial contracts that are similar to forwards. The primary difference between futures and forwards is that future contracts can be traded on exchanges, which makes them more standardised and regulated.

Swaps

Swaps are a type of derivative used to convert one type of cash flow into another. It is an agreement between two parties and are exchanged over the counter and not traded on an exchange. Currency swaps and interest rate swaps are the two most common types of swaps.

Your investments are largely affected by domestic as well as global macro conditions. Therefore, it is essential to educate yourself about the current market situations and take financial decisions accordingly.To start derivatives trading , it is important to know the basics, from derivatives meaning to how to trade derivatives. You should be aware of your risk-taking capabilities and available funds before trading in stocks, commodities, or derivatives.