What to do if you want to earn more money more faster than shares or bonds ……..? Derivatives does something similar.
In this article, we will understand in simple and easy language- what is Derivatives and how it works, so read the article till the end.
Note – If you want to understand the basics of share market or Share Market Working Concept from zero level then you should start with Part 1. – 📈 Share Market and Related
| Derivatives Backgrounds
Broadly speaking, derivatives are also a part of the stock market and this too is implemented through the stock exchange itself. However, some derivatives also have separate exchanges. For example, if we talk about commodity derivatives, then there is a separate exchange for it in India. We will understand what this happens later.
Derivatives are one of the fastest ways to make money in the capital market . With this method, profit can be made in the least amount of money. But the point is that if the profit is high then the risk is also very high. Some people come to this market only for the purpose of earning a lot of money, while some people come to reduce their risk. How all this happens, we are all going to understand further.
| What is Derivatives?
Securities can be broadly divided into three parts – (1) Equity securities, (2) Debt securities and (3) Derivatives securities. You can see this in the chart below.
⚫ That is to say, a derivative is also a security that has a monetary value. But the thing to remember here is that it does not derive its value from itself but from something else.
That is, any instrument which does not have any value of its own, but its value is obtained from something else. They are called derivatives .
In other words , any instrument which has no value of its own but its value depends on something else. The thing on which its value depends is called the underlying asset. What does all this mean, let us understand it with an example.
| what is derivative ; understand by example
Suppose you have been circling a government office for several days and your work is not being done. But one day you talk to a big officer and he writes something on a paper and gives it to you by signing it and says that you take it and show it to that particular staff, your work will be done.
You take that paper and you’re done. So you think to yourself whether that paper had any value. Not at all, the paper itself had no value. Its value is due to the sign that that competent authority has put on it. That is, that paper is getting its value from somewhere else. That’s what derivatives are.
⚫ From where it is getting its value i.e. that sign, it is the underlying asset of that paper. Because if it was not a sign, the paper would have no value. You can take many such examples from around you.
For example , take a bank note, it is just a piece of paper. But it has a value of its own as RBI approves it. That is, the value of a bank note is being received from RBI, that is why RBI became the Underlying Asset of that note.
⚫ Similarly, suppose there is cheese. It has no value of its own. Its value depends on the milk from which it is made. According to the price of milk, the price of cheese will also change. That is, in this case, milk is the Underlying Asset of that cheese.
⚫ Similarly, if we take petrol, it has no value in itself, its value depends on crude oil. That is, it gets its price from crude oil, that is why the Underlying Asset of Petrol has become Crude Oil.
⚫ Similarly, suppose there is a share of Reliance, then that share has no value of its own. Its value is derived from the company’s net worth and demand and supply. That is why the Underlying Asset of the share is that company or market.
| Commodity Derivatives – If the Underlying Asset of any Derivatives is any commodity like Wheat, Rice, Potato, Cotton, Gold, Silver etc. then we call it Commodity Derivatives .
| Financial Derivatives – Similarly, if the Underlying Asset of a derivative is an instrument such as a stock, index, etc., then we call it financial derivatives .
When we buy or sell stock or shares of a company, it is called stock trading or investing . But if we buy or sell derivatives of a company by not buying or selling its stock, then it is called Stock Based Derivatives Trading. We will understand further how this happens.
Q. When we can invest in shares and earn money from it, then what is the need of derivatives?
The fact is that the stock is best suited for long term investment. But if you want to print a lot of money in a short span of time, then derivatives are best suited for this.
More and more money can be earned from this in a very short time. How all this happens, everyone is going to understand further. Let us first talk about the types of derivatives.
| Types of Derivatives
There are four types of Derivatives –
1. Forward Derivatives
2. Future Derivatives
3. Option Derivatives
4. Swap Derivatives
We are going to understand all of them one by one in different articles, so that we can understand in detail how it works. So let’s start with forward derivative ;