Derivatives and advanced market conceptsModule 1, lesson 1 of 21
What derivatives are
What derivatives are, exchange-traded and over-the-counter contracts, hedging and speculation, and why derivative trading is zero-sum before costs.
In this lesson
- Explain what a derivative is and name its underlying asset.
- Distinguish exchange-traded derivatives from over-the-counter contracts.
- Describe how derivatives are used for hedging, speculation and arbitrage.
- Explain why derivative trading is zero-sum before costs and negative-sum after them.
Builds on
- The risks of investing in sharesDerivatives magnify the market risks explained there.
- Probability and expected valueThe zero-sum argument uses expected value.
On this page
In simple terms
A derivative is a contract whose value comes from, or is "derived" from, something else, called the underlying. The underlying can be a share, a stock market index, a currency, an interest rate or a commodity such as gold or crude oil.
The most common derivatives are futures, agreements to buy or sell at a set price on a future date, and options, which give the right but not the obligation to buy or sell at a set price. The next lessons explain each one.
This path explains how derivatives work so that you can understand them, the news about them and their risks. It is not encouragement to trade them. Derivatives and leveraged trading can lead to rapid and substantial losses, sometimes larger than the money you started with.
Exchange-traded and over-the-counter
| Exchange-traded | Over-the-counter (OTC) | |
|---|---|---|
| Terms | Standardised: contract size, expiry, strike prices | Negotiated privately between two parties |
| Where | On a stock exchange | Directly between parties, often through banks |
| Counterparty risk | A clearing corporation stands between buyer and seller and guarantees settlement | Each side relies on the other to pay |
| Who uses them | Individuals, institutions | Mainly companies, banks and institutions |
In India, futures and options on shares and indices trade on the stock exchanges and are regulated by SEBI.
What derivatives are used for
- Hedging: reducing a risk you already have. A farmer agrees today on a price for a crop to be harvested later; an investor buys protection against a fall in a portfolio, as the hedging lesson explains.
- Speculation: taking a view on prices with a small amount of money, using the leverage built into derivatives, as the leverage lesson explains.
- Arbitrage: profiting from small price differences between related markets, as the arbitrage lesson explains.
The same contract can serve a hedger on one side and a speculator on the other.
A zero-sum transfer
When two people trade a derivative, every rupee one side gains, the other loses. Derivatives do not create profits from a growing business, as shares can. Before costs, trading derivatives is zero-sum.
Worked example: A made-up group of traders
In a month, a group of traders' winning positions gain a total of ₹10 lakh and their losing positions lose ₹10 lakh. The group pays ₹1.5 lakh in brokerage, taxes and spreads.
| Total gains | +₹10 lakh |
|---|---|
| Total losses | −₹10 lakh |
| Before costs | ₹0 |
| Costs | −₹1.5 lakh |
| Group result after costs | −₹1.5 lakh |
After costs, the game is negative-sum: traders as a group lose, and the average trader must lose. Some individuals win, but only by taking money from others, including well-resourced professionals.
What happened to individual traders
SEBI has studied how individual traders actually fared. Its study of equity futures and options, covering 2021-22 to 2023-24, found that 93% of individual traders made losses, as the investing compared with trading lesson discusses. The findings describe the period studied, but they illustrate how the arithmetic of costs, leverage and competition works against most individuals.
Why it matters
Derivatives are part of how modern markets work, and their prices and volumes appear in market news daily. Understanding what they are, who uses them and why most individual speculators lose helps you read that news and resist marketing that presents derivatives as a path to quick wealth.
Limitations
This lesson describes the basic structure. Contract terms, margin rules, expiries and taxes are set by exchanges, SEBI and tax law, and change from time to time; check the exchange's current contract specifications before relying on any detail.
Common mistakes
- Thinking derivatives create wealth for traders as a group.
- Ignoring costs, which turn a zero-sum game negative.
- Confusing hedging with speculation.
- Assuming the worst case is losing the money put in. With some derivatives, losses can be larger.
Try it yourself
- Name the underlying for a futures contract on an index and for an option on a share.
- List one hedger and one speculator who might take opposite sides of the same contract.
- Read SEBI's press release on its study of individual futures and options traders, and note the share who lost money.
Key takeaways
- A derivative is a contract whose value depends on something else, called the underlying, such as a share, an index, a currency or a commodity.
- Exchange-traded derivatives are standardised and settled through a clearing corporation. Over-the-counter contracts are private agreements that carry the risk that the other side fails to pay.
- Derivatives are used to hedge risk, to speculate on price moves with leverage, and for arbitrage.
- Before costs, one side's gain is the other side's loss, so trading derivatives is zero-sum. After brokerage, taxes and spreads, traders as a group lose.
- Derivatives can produce rapid losses, sometimes larger than the money put in. SEBI's study of a past period found that most individual traders in equity futures and options lost money.
Check your understanding
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Terms used in this lesson
- Derivative
- A contract whose value depends on something else, called the underlying, such as a share, an index, a currency or a commodity.
- Underlying asset
- The share, index, currency, commodity or other asset whose price a derivative's value depends on.
- Hedging
- Taking an offsetting position, such as a forward contract, to reduce the effect of a price or currency move on future payments or receipts.
- Leverage
- Using borrowed money, or products such as futures and options, to take a bigger position than your own money allows, magnifying gains and losses.
References
- Updated SEBI study reveals 93% of individual traders incurred losses in equity F&O between FY22 and FY24 (press release, 23 September 2024), Securities and Exchange Board of India. SEBI's study found that 93% of individual equity futures and options traders made losses over 2021-22 to 2023-24.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.