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What are Equity Derivatives

What are Equity Derivatives

The primary role of equity derivatives is to help traders manage risk. For example, if you are holding a stock and want to protect the downside risk, that can be done with equity derivatives. That is also called hedging. But equity derivatives can also be used for trading with higher leverage. These derivatives are traded in fixed lot sizes and one pay a margin and take positions. When you trade in derivatives, you can multiply your gains but there is also the risk that losses can increase if you do not put an appropriate stop loss.

Some key merits of equity derivatives

  • Equity derivatives give you leverage to trade in the markets, For example, if you buy futures of Reliance instead of the Reliance stock, you can take a similar position with lower upfront margin. The lot size of RIL is 1000 shares and in the cash market it may cost you close to Rs.10 lakhs. In the futures market you will only have to pay about 20% as margin.
  • Equity derivatives also give you arbitrage opportunities in the market. This occurs when there is a positive gap between stocks and futures. Here, the trader buys in the cash segment and sells in the futures segment, in the process locking in the spread as assured returns. The returns are similar to what you could get on a debt fund.
  • If you want to take positions in the market with limited risk, you can do so with options. Options are a right without an obligation. So you just pay a premium and then bet on the stock going up or down. If it works, then profits are unlimited. If the trade does not work then your losses are just limited to the marginal premium that you will pay on the option.
  • Derivatives help you to manage the risk of your cash market positions. This is the most important role played by derivatives. For example, if you are holding a stock then you can protect your downside risk by purchasing a put option of the same stock. You can also use index options to protect the value of your complete portfolio.
  • You do not require a separate trading account to trade in equity derivatives. Your existing trading account itself is good enough for trading equity derivatives. Of course, in terms of compliance there are some additional requirements for trading in derivatives since SEBI wants to ensure that you are aware of the risks of derivatives trading.

Three things you must know about equity derivatives in India

There are some unique features about the way derivative transactions are executed in India. You need to be aware of the same.

  • All equity derivative positions in India are cash settled. That means if you are holding futures or options then the profits or losses on the last day of the contract will be settled in cash. You cannot go to the exchange and demand delivery of the stocks against your futures or options position. Of course, there is now a plan to force compulsory delivery on selected stock futures.
  • All futures and options are contracts that expire on the last Thursday of each month. Since they are contracts the can only exist in your trading account and you can hold them in your demat account. At any point of time there are 3 monthly contracts available for trading in equity derivatives which is near-month, mid-month and far-month.
  • They are highly flexible and equity futures and options can be effectively combined with one another to create limited risk strategies. These are called hybrids.
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