What are Derivatives in Stock Market? 4 types of derivatives – Best Trader’s Secret

Last updated on April 11th, 2024 at 12:46 am

In this article, we will study about What is derivatives in stock market. For a simple summary its a high risk and high return trading contract. For any investor who likes the high risk and return, Derivatives are the way. 

I am a finance student, idle money sounds like being poor to me, because it isn’t going to be idle be used for some expense somehow. I believe its better to invest this idle money in the market.

The market offers several market instruments for investing your money. One of the high return markets is the stock market. There are several types of investment we can do in the stock market. And If you are a person with a “Go big or Go home” mentality, trading is the way for you. 

And if you have market knowledge and investment knowledge, then you should dive for derivatives in the stock market. Allow me to elaborate about what are derivatives.

What are Derivatives in Stock Market?

In Simple terms, Derivatives are a contract. The value of this contract depends not the value of the underlying asset such as stocks, commodities, market indexes, etc. 

Derivatives is a contract between two or more parties whose value depends upon the fluctuating value of the underlying asset. The value of the underlying asset is independent. Derivatives can be used to hedge a position or speculate the movement of the value for underlying assets or leverage holdings.

Derivatives in Stock Market are generally traded on Central Exchange or Over-The-Counter. And even though Over-The-Counter possesses more risk than Central Exchange, the derivatives market consists more of OTC derivatives.

Derivatives are traded in the secondary market. Derivatives have an expiry date as its a contract.

Now, onto the next part is Components of Derivatives in Stock Market.

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Components of Derivatives Contract

There are 3 main components of Derivatives in Stock Market, they are as follow:

• The contract size refers to the number of units involved in the exchange.
• When the contract is being made, the expiry date is also decided at the time. The exchange must take place before the expiry date.
• When the contract is made, the parties involved in the trade agree upon a price for exchange in future. 

Types of Derivative Contracts

The Derivative contract in Stock Market comes in 2 types – Exchange Traded and Over-The-Counter.

Exchange Traded Derivatives

These derivatives are traded through an intermediary called Central Exchange. For example – In a supermarket, the buyers are connected to the vegetables which came from the farmer i.e. the seller. The supermarket is the exchange which connects the buyer and the seller.

While trading through Exchange, the rules and regulations set by the Exchange have to be followed by the buyers and sellers. Futures contracts are a perfect example of Exchange traded securities.

Over-The-Counter Derivatives

Over-The-Counter derivatives are directly traded between the buyer and seller without any middleman mediating the trade. It’s like buying the vegetables directly from the farmer i.e. the seller.

As there is no middle to set the rules and regulations, the buyer and sellers can customize the contract according to their personal preferences. A Forward contract is a perfect example of an Over-The-Counter derivatives instrument.

Now, lets move onto the next part of Derivatives in Stock Market, the Types of Derivatives in Stock Market.

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Types of Derivatives in Stock Market

There are 4 main types of Derivatives in Stock Market. They are discussed below:

Future

A future contract is an agreement between 2 parties to complete the trade in future at a predetermined price before the expiry date. Future contracts are standardized and Exchange traded. The future date decided to trade on is known as delivery date. And as Future contracts are traded on Exchange, they have to follow the rules and regulations set up by the exchange.

Forward

Forward contracts are almost identical to future contracts. The only difference is that unlike future contracts, Forward contracts are traded Over-The-Counter. Which means, The contract can be customized according to personal preference of both the parties.

Swaps

Swaps are a bit different from the other three Contracts. Here, both the parties trade privately on their own terms. In a swap contract, the buyer and sellers agree to trade on cash flow in the future as per the predetermined delivery date and future price.

Options

Option contracts are like future contracts where the buyer and seller trade on a predetermined delivery date with predetermined price. The only difference between them is that in option contracts, the parties aren’t obligated to buy or sell. In other words, the contract is not a commitment, it’s just an opportunity.

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FAQs

Closing Statement

Trading in Derivatives is a dynamic and high return opportunity. Many people are making thousands daily just by trading. The only thing required here is capital and market knowledge, or you can also be a broker and invest others’ money under supervision if you want to learn trading. 

To be an investor in Derivatives in Stock Market, you must know about these factors mentioned above. Now that you are aware about it, go Trade and make big bucks.

I hope this article about Derivatives in Stock Market was useful and informative to you. If there are any doubts or suggestions, click and capitalize it in the comment box.