It was in the year 2000 when the derivatives market was introduced in India. Since the day of its introduction, the Indian Derivatives market is gaining great significance among Indian traders and its counterparts abroad.
Just like shares, derivatives are also traded in stock exchanges. The popularity of the derivatives market can be gauged by the daily turnover in the derivatives segment on the exchange. The daily turnover in the derivatives market is much higher than the turnover in the cash segment on the exchange.
Before finding out the pros and cons of derivatives trading, let us recall what derivatives are.
What are Derivatives?
A derivative is a contract or a product that derives its value from an underlying asset. The underlying assets deriving the value of these financial contracts include stocks, commodities, bonds, currencies, exchange rates, or even the rate of interest.
In the derivatives market, the traders earn profit by speculating on the price of the underlying assets. The buyers and sellers of the derivatives contracts have opposite estimations of the future trading price of the contract. Both, the buyers and the sellers bet on the future price of the underlying asset to make a profit from derivatives trading.
The different types of derivatives available for traders to trade include futures, options, swaps, and forwards. While the participants of the derivatives market include hedgers, traders, speculators, arbitrageurs, and margin traders.
Though derivatives trading is gaining traction at a fast pace among traders, derivatives trading should be carried out with caution as there is an element of risk involved. Just as a coin, derivatives trading comes with its own sets of pros and cons.
Here are some of the pros and cons which you should be aware of before becoming a derivatives market participant.
Advantages of Derivatives Market Trading
Following are the advantages offered by derivatives trading to its participants:
Reduced Transaction Cost: Derivatives instruments are used as risk management tools and hence play an important role in reducing market transaction costs. This is the prime reason why the cost of transactions in derivatives trading is lower when compared to stock trading.
Great Risk Management Tools: The value of the derivatives contracts is linked directly to the underlying asset’s value. Hence, derivatives are used as financial instruments to hedge the risks associated with changing price levels of the underlying assets. For instance, Mr. Shah holds a derivatives contract the value of which moves in the opposite direction to that of the underlying assets. Hence, if the value of the underlying asset declines, Mr. Shah can recover the losses from the profits earned in derivative contracts.
Market Efficiency: Derivatives market is used extensively by arbitrageurs. An arbitrager plays a vital role in ensuring that the market reaches equilibrium and the prices of the underlying assets are correct.
Determining Prices of Underlying assets: Derivative contracts are frequently used to determine the prices of the underlying assets. For instance, prices of the spot contracts can be used to determine the value of the underlying commodity deriving the value of the spot contract.
Access to Unavailable Markets and Asset classes: Global financial markets are vast making it difficult for organizations and traders to have direct access to every asset or market. For instance, interest rate swaps can be used by a company to obtain a more favorable interest rate relative to interest rates that are available from direct borrowing. The derivatives market, therefore, help you in gaining access to all the unavailable markets and assets.
Transferable Risk: Derivative contracts allow investors, businesses, and other participants involved to transfer the risk to other parties.
Disadvantages of Derivative Market Trading
Apart from offering advantages, derivatives market trading comes with certain disadvantages as well. Following are the consequences of derivatives trading:
Involves Higher Risk: Derivative market instruments are highly volatile. The prime reason for the volatility is the rapidly fluctuating value of the underlying assets. Thus, the volatile nature of the derivatives contract can lead to huge losses. Furthermore, it is difficult and complicated for investors to valuate derivatives, and hence, the risk associated is higher when compared to other stock market instruments.
Involvement of Counterparty Risk: The derivatives contracts that are traded on the exchange like on the BSE or NSE are regulated and well organized. However, the derivatives traded Over-The-Counter like forwards are not standardized or regulated and hence there is a counterparty risk involved in these derivatives contracts.
Speculative Nature: Derivative market instruments are widely used as instruments of speculation. Derivative contracts are not only risky but at the same time are highly unpredictable. Unreasonable speculation in derivative contracts can lead to huge losses. The unpredictable nature can lead to wiping out a significant portion of your capital invested.
Almost every asset traded in the financial market comes with its own set of pros and cons and derivatives are no exception. Trading in derivatives requires a lot of knowledge and experience. Therefore investors need to conduct thorough research regarding the process and formulate effective strategies to minimize losses and optimize profits.
Naresh is an Expert Financial Advisory at Raghunandan Money. When it comes to studying markets, Naresh loves decoding stock prices, analyzing data, and understanding market trends. He has a deep knowledge and flair for both fundamental and technical analysis which makes him one of the most reliable experts in Raghunandan Money. Naresh is involved in training and writing informative blogs and articles on equity, commodity, traders, and investors.
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