Demystifying Derivatives in the share market ;A comprehensive Guide

 

Derivatives are a key financial instrument used in the share market to manage risk, speculate on price movements, and enhance investment strategies. However, they can be complex and intimidating for many investors. In this blog post, we will demystify derivatives and provide a comprehensive guide to understanding how they work in the share market.

What are derivatives?                                                                                                                                                                                                            Derivatives are financial contracts that derive their value from an underlying asset, such as stocks, bonds, commodities, or currencies. They are called derivatives because their value is derived from the price movements of the underlying asset. Derivatives are traded on exchanges or over-the-counter (OTC) markets and are used by investors to hedge against price fluctuations, speculate on market movements, and enhance their investment strategies.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      Types of derivatives: There are several types of derivatives used in the share market. Let's take a closer look at some of the most common ones:

Futures: A futures contract is an agreement between two parties to buy or sell an underlying asset at a specified price on a future date. Futures contracts are standardized and traded on exchanges. They are commonly used by investors to hedge against price risks or speculate on price movements.

Options: An option is a contract that gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified price within a certain period of time. Options are used by investors for various purposes, such as hedging, speculation, and income generation.

Swaps: A swap is an agreement between two parties to exchange cash flows based on the performance of an underlying asset. There are different types of swaps, such as interest rate swaps, currency swaps, and commodity swaps. Swaps are used by investors to manage risks associated with interest rates, foreign exchange, and commodities.

   How do derivatives work? Derivatives enable investors to manage risks or speculate on price movements without owning the underlying asset. Let's understand how they work with an example:

Suppose you own 100 shares of XYZ Company, and you are concerned that the stock price may decrease in the future. To protect yourself against this risk, you can sell futures contracts for 100 shares of XYZ Company at the current market price. If the stock price indeed drops, the value of the futures contracts will increase, offsetting the loss in the value of your shares. On the other hand, if the stock price goes up, the value of the futures contracts will decrease, but you will still benefit from the increase in the value of

your shares.