Derivatives Advantages & Disadvantages

Introduction

In yesteryear, derivatives trading was limited to financial institutions, big brokerage houses, high net worth individuals, and foreign and domestic institutional investors. But thanks to the easing of regulatory norms by the Securities and Exchange Board of India (SEBI), retail investors can conveniently enter into and exit from derivatives contracts with a Demat and trading account. However, is derivatives trading easier than buying or selling equity stocks? Probably not, a reason why you must know the advantages and disadvantages of derivatives trading in India before taking the plunge.

Before discussing the advantages and disadvantages of derivatives trading, let's briefly understand the meaning of derivatives.

Derivatives - A Primer

Derivatives are legal, financial instruments deriving value from another financial instrument, known as the underlying asset. The underlying asset may be an index like NIFTY or BANKNIFTY, commodities like gold, silver, etc., currencies like GBPINR, USDINR, etc., or stocks on the F&O list released by the National Stock Exchange (NSE).

The price of a derivatives contract depends on the price of the underlying asset. A derivatives contract specifies the purchase or sale price, the expiry date, the contract value, and other specifics. There are four (4) types of derivatives in India - futures, options, forwards, and swaps. While futures and options are traded through a stock, commodity, or currency exchange, forwards and swaps are traded over the counter.

Derivatives Trading - Advantages and Disadvantage

Here are the top advantages of derivatives trading in India:

1. Hedge Risk

The top reason people use derivatives is to hedge against cash positions in the underlying asset. For example, if you bought 100 shares of XYZ stock in the cash market, you can buy one lot Put (assuming 1 lot = 100 shares) in the derivatives market. Now, if the share price declines, the price of the Put contract will most likely increase, thereby minimising your loss. And, if you are lucky, you can also fetch decent gains.

2. Determine the Asset Price

Some investors use the Open Interest of stocks and indices to guess the underlying asset's direction. They use the Put-Call Ratio (PCR) to gauge the investor sentiment before placing bets.

3. Access Otherwise Inaccessible Market

Derivatives let you access otherwise inaccessible markets. For example, derivatives let you swap the interest rate to get more competitive rates than direct borrowing. Also, you can buy indices like NIFTY or BANKNIFTY through derivatives.

Now that you know the advantages of derivatives, let's understand the disadvantages of derivatives trading.

1. High Leverage

Derivatives trading is highly leveraged. For instance, you may initiate a trade worth INR 1 lac by paying 10% - 15% of the trade amount as the initial margin. While it's true that the profits may be good, so can be the losses. Hence, you must exercise caution while placing trades in the derivatives market and stay away from too-good-to-believe stories surrounding the underlying asset.

2. Speculation May Lead to Losses

The derivatives market in India is a speculative market. In fact, the derivatives market is highly volatile. Unlike equity, there is no circuit level in derivatives instruments. Hence, both profits and losses may instantly go out of hand.

3. Counterparty Risks

While futures and options are traded through an exchange and are standardised, forwards and swaps occur over the counter and hence, expose you to counterparty risks.

Minimise Risks With The Right Broker

After knowing the advantages and disadvantages of derivatives, the next best step is to open a Demat and trading account. 5paisa is a reputed Indian stockbroker facilitating trading in high-yield investment instruments. Read the resource section to pick time-tested strategies and trade like an expert.