Derivatives and their types

A derivative is a contract whose value depends on something else: a share, an index, a currency, gold, an interest rate. It lets you gain or lose from that thing’s price without owning it. That makes derivatives useful for protection, and dangerous for anyone who forgets how much they magnify.

Something that takes its value from something else

The thing a derivative’s value depends on is called the underlying. A Nifty futures contract takes its value from the Nifty 50 index; a gold futures contract from the price of gold; a USD/INR contract from the exchange rate. You can trade the contract without ever owning the underlying.

Why they exist

• Hedging: reducing a risk you already have. An exporter who will be paid in dollars in three months can fix today’s exchange rate. A farmer can lock in a price for a crop before it is harvested.
• Speculation: taking on a risk on purpose, in the hope of profiting from a price move, usually by putting down only a fraction of the underlying’s value.
• Arbitrage: profiting from small gaps between related prices, such as a future and its underlying. Doing it also keeps those prices in line with each other.

The same contract can serve any of the three. What differs is whether it reduces your risk or adds to it.

The four basic kinds

1. Forwards. A private agreement to buy or sell something at a fixed price on a future date.
2. Futures. The same promise, standardised and traded on an exchange, with gains and losses settled every day.
3. Options. The right, but not the obligation, to buy or sell at a fixed price. The buyer pays for that right.
4. Swaps. An agreement to exchange one stream of payments for another, such as a fixed interest rate for a floating one.

The next three lessons take forwards, futures and options in turn.

Where they trade in India

Futures and options on indices such as the Nifty 50, and on individual shares, trade on NSE and BSE. Commodity derivatives trade mainly on MCX, and currency derivatives on NSE and BSE. Forwards and swaps are mostly private arrangements, typically between banks and companies, outside any exchange.

Leverage: the part that bites

To trade a future, you don’t pay its full value. You put down a margin, a deposit worth only a fraction of it. That makes every move in the price larger in proportion to your own money, in both directions.

With a 20% margin, a 4% fall in the underlying costs you 20% of your money. A 20% fall takes all of it, and anything larger leaves you owing more than you put in.

This is the main reason derivatives are riskier than they look. A SEBI study published in September 2024 found that 93% of individual traders in equity futures and options lost money over the three years to March 2024.

Work it out on your own numbers

• Options calculatorPrice an option, see its Greeks, and build a payoff for any strategy.

This lesson explains ideas. It is not advice about what to buy, sell or hold.