Unlocking the Potential: Exploring Derivative Trading and its Opportunities

• Introduction

Derivative trading is a dynamic and popular investment strategy that revolves around the buying and selling of financial instruments known as derivatives. These derivatives derive their value from underlying assets such as stocks, bonds, commodities, currencies, or market indices. Unlike traditional investments where one directly owns the underlying asset, derivative trading allows investors to speculate on price movements and leverage their positions to potentially amplify their returns. With its ability to offer diverse opportunities and manage risks effectively, derivative trading has gained significant traction in financial markets, attracting both individual and institutional investors seeking to capitalize on market fluctuations and optimize their investment strategies.

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• What is Derivative Trading?

The financial market system in India can be broadly classified into two areas; the cash segment and the derivative segment. The cash segment has always been an investor favourite of the investors. However, India has witnessed a huge surge in derivatives’ turnover and trading volume in the past few years.

This turnover surge is seen as unprecedented and meteoric, as it has even managed to surpass the volumes of the cash segment. Such investor interest has established derivatives as an ideal investment instrument that is more than worthy of being heavily profitable to investors. However, to invest in derivatives, it is vital that you understand derivatives in detail.

• What is the meaning of Derivative Trading?

A derivative is a formal financial contract that allows an investor to buy and sell an asset for a future date. The expiry date of a derivative contract is fixed and predetermined. Derivative trading in the share market is better than buying the underlying asset since the gains can be substantially inflated.

Moreover, derivative trading is a leveraged form of trading, meaning you can buy a large quantity of the underlying assets by paying a small amount. You can trade in different types of derivatives, such as stocks, commodities, currencies, benchmarks, etc.

Derivative contracts are of two types - futures and options. In essence, both are the same since the investor, and the seller predicts the price of the underlying asset for a specific future date. But, futures and options are different in that, in futures, both the buyer and seller are under the legal obligation to honour the contract on expiry.

However, in the case of options, the buyer or seller can buy/sell before expiry by exercising their rights or letting the contract expire without any exercise of rights. Options are of two types - Call option and Put option. Investors buy a Call option when they are confident that the underlying asset will go up. In contrast, they buy a Put option when they feel certain that the price of the underlying asset will come down.

Derivative trading strategies

Derivatives trading occurs through futures or options contracts between two parties at stock exchanges like NSE and BSE and commodity exchanges like MCX, NCDEX, ICEX, etc. Some derivative instruments are also traded over the counter. The price of a derivatives contract depends on an underlying asset, such as a stock, index, currency, commodity, or even interest rates. Derivative prices are highly reactive to the underlying asset's price.

If the underlying asset's price increases, the derivative price may also increase and vice versa. Read on to learn about some popular derivative trading strategies expert investors rely on to make money from through this financial instrument. 

However, while these strategies are time-tested, meaning they work on all market conditions, there is no holy grail method of making money from derivatives trading. It is always prudent to backtest the derivatives trading strategies enlisted here and find the one that best suits you. 

•Futures Trading Strategies

Futures traders trade in two directions - long (buy futures) or short (sell futures). Here are the four most popular futures trading strategies: 

1)Long Trades 

Long trades are a common form of trading futures. When you purchase futures, you feel confident that the price of the underlying asset will increase before the contract expiration date. The further the price goes above the price agreed by you and the seller (strike price), the more profits you can make. 

2) Short Trades 

Short trades refer to selling futures. When you sell a futures contract, it means you are confident that the price of the underlying asset will decrease before the contract expiration date. Short trades are generally considered riskier than long trades since the losses can be substantial if the price moves in the opposite direction. 

 

 

3) Bull Calendar Spread 

The trader buys and sells futures contracts on one underlying asset but for different expirations in this futures trading strategy. The trader usually goes long on the near-term expiry and short on the long-term expiry. Investors adopting this strategy expects the spread to widen in favour of long to increase their profit margin.

4) Bear Calendar Spread 

Bear calendar spread is the opposite of the bull calendar spread. In this futures trading strategy, a trader goes short on the short-term contract and long on the long-term contract. Investors preferring this strategy expect the spread to widen in favour of short so as to make a higher profit. 

• Options Trading Strategies

Options are of two types - call and put. The call option gives a trader the right to purchase the underlying asset at a predecided price in the future. In contrast, the put option entitles the trader to sell the underlying asset at a predecided price in the future.

Here are the most common options trading strategies traders rely on:

1) Buy Call 

Long call is one of the most popular investment instruments in options. You can place this trade when you are confident that the underlying asset and the corresponding strike price will go up before the contract expiry date. Remember, time is an enemy of options. The faster the underlying asset's price moves above the strike price, the faster you profit. However, if the price goes up on the final date of contract expiry, you may incur a loss. 

2) Buy Put 

When you buy put, you expect the underlying asset to go down in the future or before the contract expiration date. If the underlying asset drops below the strike price, you make a profit. However, if the asset price increases, your premium value (the price you paid to buy the put) may become zero. 

• Covered Call Strategy

In this options trading strategy, you buy an underlying asset in the spot market and sell a call of the same asset. This approach is adopted by investors who maintain a neutral to a bullish stance. In terms of the risk-reward ratio, the reward is limited, but the losses may be unlimited. Moreover, volatility might cause additional trouble for a trader relying on this strategy for making a profit. 

1) Married Put Strategy

In this strategy, an investor buys a put option for the shares they already own or intend to buy. Investors who are generally bullish on a stock adopt this strategy to minimise the impact of a fall in prices.

• Tax on derivative trading

derivative trading is subject to the provisions of the Income Tax Act, 1961. The tax on derivative trading is categorized under capital gains tax. The gains or profits made from derivative transactions are considered as capital gains and are taxed accordingly. Short-term capital gains, resulting from the sale of derivatives held for less than one year, are subject to different tax rates than long-term capital gains.

It's crucial for traders to maintain accurate records of their derivative transactions, including purchase and sale details, to calculate their taxable gains. Losses incurred from derivative trading can be set off against other capital gains, reducing the overall tax liability. Additionally, if there are unused losses, they can be carried forward to subsequent years for adjustment against future gains.

To ensure compliance with tax regulations and optimize tax liability, traders are advised to consult with tax experts or chartered accountants. They can provide guidance on tax planning strategies, deductions, and any specific provisions that may be applicable to derivative trading. By staying informed about tax obligations, traders can navigate the derivative market effectively and make informed decisions regarding their investments.

• Scope of derivative trading in india

Derivative trading in India has witnessed remarkable growth and presents a wide scope of opportunities for investors. With the introduction of derivative products on major stock exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE), the market has expanded, providing investors with diverse options to participate in derivative trading.

The scope of derivative trading in India is vast, offering opportunities for various market participants, including retail investors, institutional investors, and traders. The availability of different derivative products, such as futures and options, allows investors to hedge their positions, speculate on price movements, and diversify their portfolios. This increased market participation has resulted in greater liquidity, improved market efficiency, and a more inclusive trading environment.

Derivative trading also plays a crucial role in risk management. It provides investors with tools to mitigate risks associated with price fluctuations in the underlying assets. This aspect is particularly beneficial for businesses exposed to price volatility, such as commodity producers, exporters, and importers. By utilizing derivatives, these businesses can hedge their positions and stabilize their financial positions, reducing the impact of adverse market movements.

Furthermore, the development of derivative trading has contributed to the growth of a robust and liquid market in India. The availability of derivative contracts on various asset classes, including equities, commodities, currencies, and interest rates, has attracted a diverse range of market participants. This increased participation has led to enhanced market depth, tighter bid-ask spreads, and improved price discovery mechanisms. As a result, traders can execute trades more efficiently, benefiting from competitive prices and improved market transparency.

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• Conclusion 

In conclusion, derivative trading in India presents a wide scope of opportunities and growth potential. With the availability of diverse derivative products on major exchanges, investors have the chance to participate in this dynamic market. Derivative trading allows for increased market participation, effective risk management, and the development of a robust and liquid market. By utilizing various strategies and staying informed about market trends, investors can capitalize on price movements, diversify their portfolios, and potentially achieve significant returns. With its allure and potential for financial growth, derivative trading continues to attract investors seeking to optimize their investment strategies and navigate the exciting world of derivatives.

• Summary

In summary, derivative trading in India offers an enticing avenue for investors to explore. With its potential for high returns, risk management capabilities, and evolving market landscape, derivative trading opens doors to diverse opportunities. By carefully analyzing market trends, employing effective strategies, and staying informed about regulatory requirements, investors can tap into the vast potential of derivative trading. Whether it is hedging against market volatility, speculating on price movements, or diversifying investment portfolios, derivative trading provides the tools and scope for investors to enhance their financial prospects in the ever-evolving Indian market.