It would be nice if one invested in the stock market for the long term. The stock market yields the best results if you focus on long-term investing. Yet, on the other hand, many individuals try to secure instant profits by applying trading strategies like intraday trading. The reason share markets hold fortunes for different kinds of investors is that there are many types of assets. While stocks allow investors to take advantage of companies’ growth by gaining ownership, debt instruments like bonds or treasury notes provide reliable investment options. Likewise, derivatives contracts are also significant securities that can generate good returns. Derivatives trading involves securities valued on the basis of underlying assets.
What are derivatives?
In this article, we shall look closely at the four different types of derivatives. For starters, we begin by defining derivatives. Derivative trading actually involves financial contracts. This contract allows the trading of assets between two parties or investors, referred to as counterparties. Certain predetermined terms and conditions bind the counterparties. The rights and obligations of both parties are subject to the agreement made between them. Derivatives do not have any direct value of their own. Their worth is derived from the underlying assets. These assets can include equity, commodities, or other financial instruments. The expected future price trends of these assets In India, the Securities Contracts Regulation Act of 1956 defines and governs derivatives trading.
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The 4 Types of Derivatives Contracts
There are four types of derivative trading contracts: forwards, futures, options, and swaps.
Forward contracts are private agreements between two parties. The buyer is required to purchase, and the seller is required to sell the asset at the specified price and date in the future.The transaction price is set in the contract itself. The party buying the asset is known as the long side, and the one selling it is known as the short side. The assets traded in forward contracts usually include daily-used commodities such as grains, oil, fruit juices, natural gas, precious metals, etc. As the forwards market grew popular, even foreign currencies and other financial instruments became part of the basket of assets. The obligation to buy or sell the contract can take place in two ways: by delivery (known as “deliverable forward”) or by cash (called “non-deliverable forward”).
The futures contract refers to an agreement between the buyer and seller to execute the transaction at a fixed future date. Contract trades occur on the futures exchange. It is subject to the daily settlement mechanism. Futures contracts grew out of forward contracts only. Hence, there are many similarities between the two types of derivative trading. The difference lies in the fact that future contracts get traded on exchanges referred to as “future markets.” In futures contracts, every particular thing is explicitly mentioned. Quantity, quality of the commodity, fixed price per unit, date, and also the delivery method Yet, a trader can terminate a futures contract by executing an offset transaction, which is an opposite transaction of the same value as the opened position.
Options contracts are derivatives trading agreements between counterparties that give them the right but not the obligation to carry out the transaction.An option holder may or may not buy or sell the asset at the expiry date, depending on the decided price. Options contracts mostly include securities and commodities, apart from real estate transactions. Options establish a fixed price, called the strike price, to execute the contract. It also has an expiration date, after which its value erodes away. Options contracts are of two kinds.
- Call option: The owner of a call option has the right to buy the underlying asset at a specific price until the option expires.
- Put Option: The owner of a put option reserves the right to sell the underlying asset until the specified date.
Companies make swap agreements where they exchange cash flows. They set a predetermined calculation method to get funds for future use. So, swaps are portfolios of forward contracts. Derivatives trading for swaps takes place on over-the-counter derivatives markets. The two most common types of swaps are currencies and interest rates.
- Interest rate swaps are agreements to exchange a stream of interest obligations for the other party during a period of time.
- Currency swaps: Currency swaps obligate both parties to exchange interest payment streams. The interest rate for each one may differ.
All these types of derivative contracts are useful instruments for transferring the risk associated with assets. Those willing to take on more take part in regular derivative trading. Moreover, derivatives trading is now possible with popular stockbrokers like Share India. It offers all of the services needed to participate in the derivatives market, including a trading account.