Newsletter 63: Derivatives and Futures: A Primer
Nitin Rajput
AGM - Head of Learning And Development | Airpay Academy | Ex NPCI | Ex General Mills
Ajay's Curiosity About Derivatives Trading
Ajay had been successfully managing his investment portfolio, diversifying across stocks, mutual funds, REITs, and INVITs. However, during a recent conversation with a trader friend, he heard about futures, options, and derivatives—a world of high-risk, high-reward financial instruments.
Intrigued but cautious, Ajay decided to dig deeper. What exactly are derivatives? How do they work? And most importantly, do they fit into his financial strategy?
Understanding Derivatives: The Basics
A derivative is a financial instrument whose value is derived from an underlying asset—such as stocks, commodities, currencies, or indices. Instead of directly buying or selling these assets, traders use derivatives to speculate on price movements or hedge against risks.
The most common types include:
?? Futures Contracts
? Agreement to buy/sell an asset at a future date for a fixed price.
? Used by traders to speculate on price movements or hedge risk.
? Example: Ajay could enter a NIFTY futures contract, betting that the index will rise in the next month.
?? Options Contracts
? Right (but not obligation) to buy/sell an asset at a fixed price before expiration.
? Two types:
? Example: Ajay could buy a call option on Reliance stock, expecting its price to rise.
?? Other Derivatives
? Swaps: Used for interest rate or currency hedging.
? Forwards: similar to futures but customized and traded privately.
The High-Risk Nature of Derivatives
Ajay quickly realized that derivatives aren’t for the faint-hearted. They come with:
?? Leverage Risks: Small price movements can lead to huge gains or devastating losses.
?? Time Decay: Options lose value as they approach expiration.
?? Market Volatility: Sudden price swings can wipe out investments.
One statistic caught his attention: More than 90% of retail options traders lose money over time. This made Ajay question whether he wanted to enter this space.
Potential Rewards of Derivatives Trading
Despite the risks, derivatives offer powerful advantages for seasoned investors:
? Hedging Protection: Investors can hedge against stock market downturns.
? Profit from Market Movements: Gain from both rising and falling markets.
? Leverage: Small investments can control large positions.
Should Ajay Trade Derivatives?
Ajay took a step back and asked himself some critical questions:
?? Do I have a deep understanding of market movements? → Not yet.
?? Can I afford to take losses? → Not at the cost of his long-term goals.
?? Do I want to speculate or protect my investments? → More inclined towards protection.
After much thought, Ajay decided to learn more but stay cautious. Instead of jumping in blindly, he would explore using derivatives as a hedging tool to protect his portfolio, rather than purely for speculation.
Key Takeaways for Beginners in Derivatives Trading
?? Educate Yourself First: Don’t trade without understanding how derivatives work.
?? Start Small—If experimenting, use minimal capital.
?? Use for Hedging, Not Gambling: The primary purpose of derivatives should be risk management.
?? Be Cautious of Leverage: It can amplify both gains and losses.
What’s Next?
Ajay realized that derivatives can be useful not just for speculation but also as a risk management tool. In the next newsletter, he explores hedging strategies—using derivatives to protect his investments from market downturns.
Stay tuned!