Derivatives Market For Beginners | Edelweiss Wealth Management

In this video, Edelweiss Professional Investor Research Team, shall be explaining financial derivatives and derivative trading in a very simple and concise way for beginners to understand.

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A financial derivative is a contract whose value depends on assets or a group of assets. The term assets in financial jargon can be classified into shares or stocks, bonds, currencies, commodities and market indices. The value of these assets are highly dynamic in nature and keep changing with the market conditions and forces.

Derivative trading involves making profits by speculating the future value of the underlying contracts.

A simple example can be stated as follows,

There is a farmer who grows wheat. He expects to sell 10 quintals of wheat in 4 months at Rs. 2000 per quintal. However, he is afraid of the risks involved in farming, like bad weather. So he decides to go to a commodities broker and enter the derivatives market. He enters into a contract to sell the wheat after 4 months at the same price. If the supply of wheat is high and the price falls to Rs. 1970, the broker is still bound to give the farmer Rs. 2000, which was the value when the contract was made. However, if the price of wheat rises to Rs. 2020, the farmer is going to incur a loss of Rs. 20 per quintal.
This is a type of a commodity derivative done using a derivative instrument called forward contract.

The 4 major types of derivative instruments are as follows:
1) Forwards
2) Futures
3) Options
4) Swaps

The first type amongst the different derivative instruments includes forwards and futures. They obligate the user into buying an asset at a pre-agreed price on a future date. The main difference between them being that futures are traded in stock exchanges while forwards are customized contracts that are not traded anywhere.

Options is a kind of financial derivative that gives the buyer the right without any obligation to buy/sell the underlying asset at a pre-determined price. There are two kinds of options - call and put option.
A call option in derivative trading, gives the trader the right but not the obligation to buy a given quantity of an asset at a given price.
A put option, on the other hand, gives the trader the right but not the obligation to sell a given quantity of an asset at a given price. However, to buy any kind of options one has to be a premium.

To get updates on futures and options, visit the link below:
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The final type of derivative instruments is swaps. This derivative allows the exchange of cash flows between two parties. The three most popular type of swaps are interest rate swaps, commodity swaps and currency swaps. This section of the video also covers one important jargon involved in derivative trading, i.e. mark to market. This involves recording the price or value of a security, to reflect the current market value rather than just the book value. This is mostly done in futures contracts.

Derivate trading has a lot of pros and cons. The pros being,
1) Hedging Risk Exposure
2) Underlying asset price determination
3) Higher returns

Below are the risks involved with these financial instruments:
1) High volatility
2) Speculative Features

It is advisable to start derivative trading only when one has about 5-6 yrs of experience in stock markets. However, with enough experience and knowledge, derivative instruments can bring in huge benefits.

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