In the stock market, you can buy and sell shares of companies. Based on these shares, derivatives instruments are also traded on the market. These instruments are an agreement to buy or sell the underlying shares in the future. This agreement is sold in the market. They are called contracts. Derivative instruments are available for shares, indices, currencies as well as commodities. Their value is tied to the underlying security.
Types of Derivative Instruments: There are two kinds of derivative instruments – futures and options. Futures are contracts or an agreement between two parties to either buy or sell a fixed quantity of assets at a particular time in the future for a fixed price. An option is also a similar contract, except the parties are not obligated to fulfill the terms of the agreement. These contracts are then traded in the market. The minimum value of a contract is Rs 2 lakh.
While dealing in the derivatives market, you are essentially betting on the future increase or decline in stock prices. As a result, many stock traders use the segment to enhance their profits. This is called arbitrage.
The most common use of derivatives trading is hedging. As part of this, you buy in the cash segment and agree to sell in the derivatives market or vice versa. Thus, you are essentially safeguarding yourself from potential losses. Hedging is mainly used by importers and exporters in the currency derivatives segment.
While trading in the derivatives market, you only pay a margin. This is because the actual value of the contracts would be too large in lakhs and crores. However, when you make a profit, the percentage of growth is exponentially higher. This allows you to make more money.