Indian Derivatives Market: Key Things you Must Know Before Investing

In this article, we will discuss

• 10 Key Things You Must Know Before Investing in the Derivatives Market
• Conclusion

The Indian derivatives market has emerged as a growing hub for trading activity in recent years. This market segment, which consists of various derivative instruments, has become particularly popular for its options and futures. Data from the Futures Industry Association reveals that in 2023, Indian options markets account for 78% of the 108 billion option contracts traded across the world. With advanced strategy builders like Options B.R.O from Samco Securities now available to customers for free, options trading has become increasingly accessible.

However, since trading volumes and retail trading activity are growing in the Indian derivatives market, all participants must know the fundamentals of this market segment. If you are a beginner to the F&O segment, this article will help you understand the key considerations and fundamental aspects of derivatives trading in India.

10 Key Things You Must Know Before Investing in the Derivatives Market

From the types of derivatives traded and the regulations in place to liquidity concerns and settlement methods, there is a lot that you need to be aware of about derivatives trading in India. Check out the details below:

• Types of Derivatives

The Indian derivatives market primarily trades four types of derivatives: futures, options, swaps, and forwards. Futures and options are the most common exchange-traded derivatives (ETDs), while forwards and swaps are over-the-counter (OTC) derivatives. Depending on the type of the underlying asset, we have commodity derivatives, interest rate derivatives and equity derivatives. These instruments are popular for their use in hedging risks, speculating on price movements and taking advantage of arbitrage opportunities.

Futures contracts require buyers and sellers to transact at a predetermined price on a specified future date. These contracts are obligatory, meaning both parties must fulfil their end of the deal on the expiry date. Options, however, provide more flexibility. A call option gives the holder the right, but not the obligation, to purchase an asset at a set price at expiry, while a put option gives the buyer the right to sell the underlying asset.

• Key Market Participants

The Indian derivatives market involves various participants, each playing a unique role in market dynamics. They can broadly be classified into three categories: hedgers, speculators and arbitrageurs. Hedgers like large corporations and institutional investors use derivatives to mitigate risks associated with their investments. They aim to protect their portfolios or assets from adverse price movements.

Speculators, like retail traders and proprietary trading firms, aim to profit from price fluctuations by taking calculated risks. They take on higher risks in hopes of achieving significant returns. Arbitrageurs, on the other hand, exploit price discrepancies across different markets or instruments.

Other key participants include market makers, who provide liquidity, and clearing houses, which facilitate the settlement of trades and manage counterparty risks. Finally, brokers and dealers facilitate trades in the derivatives market by providing the necessary liquidity.

• Regulatory Framework

The Securities and Exchange Board of India (SEBI) is the primary regulator in the Indian derivatives market. This body oversees how the exchanges, clearing corporations and market intermediaries function. It also formulates rules and guidelines to ensure fair, transparent and efficient market operations.

The Reserve Bank of India (RBI) regulates the OTC derivatives market, with a particular focus on interest rate and foreign exchange derivatives. All market participants are required to comply with regulatory requirements like reporting obligations and position limits.

• Contract Specifications

Each contract traded in the Indian derivatives market has standardised specifications. These terms, which are specifically set for futures and options contracts include the underlying asset, contract size, price quotation, tick size (minimum price movement), expiration date and method of settlement.

Futures and options contracts are available on various underlying assets like equity indices (e.g., Nifty 50, Bank Nifty), individual stocks, commodities (e.g., gold, crude oil) and currencies. It is crucial to understand contract specifications, so you can make your derivatives trading plan more effective and manage risk better.

For instance, in an equity futures contract, the underlying asset could be a specific stock or index, with a contract size that represents a fixed number of shares. The expiry date, which varies based on the type of contract, marks the date when the contract must be settled. These standardised specifications ensure uniformity and transparency in derivatives trading.

• Margin Requirements

Margin requirements in the Indian derivatives market are set by exchanges like the NSE and BSE, in line with SEBI’s regulations. These requirements determine the minimum amount of funds you must deposit to open and maintain a derivatives position.

Margins are typically divided into two categories — initial margin and maintenance margin. The initial margin is the upfront payment you need to make to initiate a position. It is calculated as a percentage of the contract’s value. The maintenance margin is the minimum amount that you must maintain in your account to keep the position open. If the account balance falls below this level due to market movements, a margin call is issued and you need to deposit additional funds.

• Contract Expiry

The Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) have collaborated to introduce daily derivative expiry. This gives traders in the derivatives market more opportunities and flexibility.

Under the new expiry calendar, each trading day of the week has a different index option expiring, as outlined below:

• Monday: Nifty MidCap Select and BSE Bankex
• Tuesday: Nifty Financial Services (FinNifty)
• Wednesday: Nifty Bank (weekly contracts)
• Thursday: Nifty50 and individual securities
• Friday: Nifty Next 50 and BSE Sensex

This arrangement allows option buyers to pay lower premiums and capitalise on volatile moves during specific days or weeks. Meanwhile, option sellers also benefit from faster time decay in option premiums stemming from shorter expiry cycles.

• Settlement Mechanism

Settlement refers to the process of fulfilling the obligations that stem from derivative contracts. The settlement mechanism In the Indian derivatives market ensures that buyers receive their assets and sellers receive their funds as per the agreed-upon terms.

For exchange-traded derivatives like futures and options, the clearing corporation acts as the central counterparty and guarantees the settlement. Cash-settled derivatives like index futures and options are settled in cash based on the difference between the contract price and the settlement price. Physically settled derivatives involve the actual delivery of the underlying asset.

The settlement cycle for derivatives contracts is typically T+1, meaning the settlement occurs on the next working day after the trade date. If you want to start or continue with derivatives trading effectively, you need to understand the settlement process and meet your obligations to avoid any penalties or legal consequences.

• Tax Implications

Profits from derivatives trading using futures and options are treated as business income for tax purposes. This classification applies regardless of how frequently or in what quantity you trade. The income is further classified as non-speculative business income.

When the total turnover is calculated for tax purposes, the absolute values of the profits and losses are taken into account. To reduce the tax burden on this income, you can claim deductions for various expenses related to your trading activities — like charges for maintaining a demat account and the cost of electricity used for trading.

If your trading turnover crosses the Rs. 10 crore mark, you need to have your accounts audited. However, if your turnover is below Rs. 2 crore, you can choose the presumptive taxation scheme and declare 6% of your total turnover as taxable income.

Additionally, in the Union Budget 2024, the Finance Minister proposed a change to the Securities Transaction Tax (STT) rates for derivatives trading. The STT rate on the sale of an option in securities has now increased from 0.0625% to 0.1% of the option premium, while the rate on the sale of a futures contract in securities has increased from 0.0125% to 0.02% of the traded price.

• Hedging Strategies

Hedging is a risk management strategy that many market participants use to protect their investments from adverse price movements. In the derivatives market, various hedging strategies can be set up with the help of futures and options contracts.

One common strategy is a long hedge, where you buy futures or call options to offset the potential losses from a long position in the underlying asset. Conversely, in a short hedge, you sell futures or put options to mitigate the risks of a short position (which is valid only in the intraday window in the cash segment).

You can also use complex hedging strategies like delta hedging, where you need to continuously adjust the hedge position based on how the delta of the option changes. Gamma hedging and vega hedging are other advanced strategies that help manage the risk of price and volatility changes in the underlying asset respectively.

• Market Timings

In India, the derivatives market operates within specific trading hours. It is crucial that you are aware of these timings. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are the two main exchanges for derivatives trading in India.

The normal trading hours for equity derivatives and currency derivatives are from 9:15 AM to 3:30 PM Indian Standard Time (IST), Monday through Friday. However, the market remains closed on national holidays. Currency derivatives have an extended trading window, operating from 9:00 AM to 5:00 PM IST. Commodity derivatives have varying trading hours depending on the specific commodity.

For instance, internationally linked non-agri commodities like bullion, energy and base metals trade from 9:00 AM to 11:30 PM or 11:55 PM IST. Internationally linked agri commodities like CPO and cotton trade from 9:00 AM to 9:00 PM IST, while other agri commodities like mentha oil trade from 9:00 AM to 5:00 PM IST.

Conclusion

The bottom line is that the derivatives market in India offers a wide range of opportunities for investors and traders to manage risk and capitalise on market inefficiencies. However, it is crucial to have a thorough understanding of the various aspects of derivatives trading, as outlined in this article.

This way, you can make informed decisions and develop effective trading strategies. Options B.R.O, a powerful strategy builder offered by Samco Securities, can further help you with this. Designed to revolutionise the way traders approach options trading, this innovative tool allows you to filter, find and analyse trading strategies in changing markets.

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