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Aditya Goela, CFA

Aditya Goela, CFA

Co-Founder and Trainer at Goela School of Finance LLP | Chartered Financial Analyst® | Proprietary Trader | JoshTalk Speaker
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What are derivatives

Aditya Goela, CFA

Aditya Goela, CFA

Co-Founder and Trainer at Goela School of Finance LLP | Chartered Financial Analyst® | Proprietary Trader | JoshTalk Speaker
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LinkedIn

If your interest lies in stock markets, we’re sure that you would have heard Future and Options or F&O. They are a hotspot where people are extremely desperate to enter. You’ll find social media to be flooded with “experts” sharing their highly lucrative profit screenshots. If you look into those trades, you’ll find that they had made profits of a ridiculous 50-100% or even more. Lalach aaya na?

Reading till now, returns would have surely pumped you up. Even you would have started your search about F&O in a separate tab, besides this blog. Take a deep breath and read us a bit more, as you only have learned about the reward, not the risk. Shockingly, people are blindly rushing to stock market training institutes, just to learn it. Most of them end up blowing up their capital because of either a  lack of knowledge or misinformation. So let’s hop into the universe (multiverse😂) of F&O, technically known as Derivatives.

F&O are weapons of mass destruction–Mr. Buffett.

What are derivatives?

What are derivatives

As the name suggests, derivatives are derivations, i.e., a developed form of something. In layperson’s terms, stock market derivatives are the developed form of an instrument (stocks, index or commodity), which you can buy or sell. This developed form is technically called a financial contract. The value of these contracts follows the movement of the underlying instrument. In most resources like share market courses online, you will find the explanation very difficult. So, let’s crack it down further into a more simplified language through an example:

Say you want to own a trading setup that costs about 6 lakhs, but because of some reasons or finite money, you can’t purchase it entirely. So you simply took the setup on a token amount, say 1.5 lakhs (1 lakh as security) for a finite time. Now you can use the full features of a 6 lakh setup. If the setup doesn’t make you profits, then you’ll be losing on the 50k you paid. But, if the setup breaks down completely, then you’ll have to reimburse the remaining cost (4.5 lakhs). This token amount plan is a derivative contract. 

These contracts between buyers and sellers are a zero-sum game, i.e. these contracts transfer money from the losing side, and lose to the other one as profits. Ultimately, in derivatives, you can make a lot of profits if you predict the correct movement of the instrument. The only catch is you have to be correct within a certain period, which is a lesser-known fact unless you do your own research or attend share market courses online. 

If the derivatives are contracts of stocks and indices only, then what is the benefit of using it? Why not trade directly?

Derivatives are special contracts through which you can trade into large volumes of stocks with a relatively moderate amount. Let’s understand this through an example:

For example, you wish to trade in Reliance on a quantity, say, 250 shares. Now if the price of Reliance is 2400Rs a share apiece, then you’ll need an amount of 6 lakh rupees, normally. In derivatives, you will require only 1.45 Lakhs to trade 250 shares. Thus, through derivatives, the capital to be put into is a fraction of the original. The disadvantage is only that the risk has now increased as these contracts are more volatile than the shares themselves. Though the exposure to loss is the same only, i.e. if Reliance went to zero, you will have the same loss as 6 lakhs. This is the benefit of going through a derivative contract.

Applications of derivatives:

After learning derivatives from a stock market training institute, people and organisations carry out following practises in the market:

  1. Short Selling:
  2. Hedging: It is a process used to minimise the risks of investments in times of correction to avoid losses.
  3. Profiting in consolidated markets: Through neutral strategies in derivatives, people can mint money if the instrument is range-bound. A regular person will probably suffer from the regular hitting of SL (Stop Hunting in such periods.
  4. Arbitrage: Making profits through trading by using price or value difference of the instruments in different segments is called Arbitrage.   

The biggest advantage of Derivatives – Short Selling

When you put your money in the cash or equity markets for over 1 day, you make a profit only and only when the market moves upwards. Thus, when the markets fall, you can only sit and watch your profits reduce and do nothing. In derivatives, you can short the market instruments for over one day. Shorting is a process through which you can sell something first (taken on loan from a broker) and bought later. Through this, you can also make money when markets fall. As per SEBI rules, you can’t short for over 1 day in the cash markets, but in derivatives markets, you can. You can watch this video to learn more about short selling:

We have explained short selling strategies in the Cash and Derivatives segment, in-depth in our stock market technical analysis course.

Risks and drawbacks of derivatives:

Like every useful tool, derivatives have the following problems:

  1. Puts high risk on capital: Warren Buffet is not completely wrong. The derivatives seem to be a lucrative offer, but if not chosen wisely, they can wipe out your entire capital. Many small retail traders jump into this segment. They think they can trade in vast quantities with contracts of token amounts (technical name: premium) in a few thousands, and make tens of thousands. It may work a few times, but when the SL gets hit or the trade goes to loss, derivatives wipe their entire capital off. Some of them are so badly stuck, they have to take loans to clear the dues off.
  2. Liquidity: One of the biggest problems in derivatives is liquidity. Suppose you take a trade in derivatives and when you wish to close it, you don’t have enough people to buy/sell them to. This case of lack of sufficient players might lead to extreme price movements, resulting in an enormous loss. 

Derivatives are a powerful tool, which when applied to a decent capital can work wonders. The only catch with derivatives is you should have proper knowledge about them and focus on capital preservation rather than appreciation as taught in stock market institutes in Noida like the Goela School of Finance.

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