What Are Derivatives? Meaning & Types in India

A derivative is a contract whose value depends on an underlying reference. The wheat agreement above is worth more or less as the wheat price moves. A Nifty futures contract is worth more or less as the Nifty moves. The contract is a separate thing from the underlying, with its own price, its own expiry date and its own rules.

Think of booking a flat by paying a token amount today. You have fixed a price for a purchase that happens later. If prices in the area rise, your booking becomes valuable. If they fall, you have fixed a price that is now too high. The booking has a value of its own, even though you do not yet own the flat. A derivative works in the same way.

People use derivatives for three main reasons. Hedgers want to reduce a risk they already have, like the farmer or an exporter fixing a rupee rate. Speculators take a view on price direction and accept the risk for a possible reward. Arbitrageurs look for small price differences between related markets. The label belongs to the position, not to the person. The same trader can hedge one day and speculate the next.

Notice what is not in the definition: leverage. Many derivatives allow a small deposit to control a large position, but that is a feature of how they are traded, not what makes them derivatives. Leverage comes up again later in this article.

A forward is a private agreement between two parties with terms they choose themselves. The farmer and the miller can pick any quantity and date. The cost of this freedom is that each side must trust the other. If the price moves a lot, the losing side may refuse to honour the deal, and there is no easy way to exit early.

A futures contract is a forward that has been standardised and moved onto an exchange. The quantity, expiry date and quality are fixed by the exchange. Gains and losses are settled every day, which is called mark-to-market, so no large loss builds up unseen. Both buyer and seller are obliged to complete the contract if they hold it to expiry, but either can usually exit earlier by taking the opposite position.

An option is different in one important way. The buyer pays a fee, called the premium, and gets a right but not a duty. Think of paying token money to reserve a house at a fixed price. If you change your mind, you lose only the token. The seller of the option receives the premium but takes on the duty to deliver if the buyer exercises. This is also how insurance works: you pay a premium, your loss is limited to it, and the insurer carries the larger possible loss.

A swap is an agreement to exchange two streams of payments. The common picture is a home-loan swap: one party pays a fixed rate and receives a floating rate, while the other does the opposite, each on an agreed amount. Swaps are privately negotiated and are mostly used by banks and companies for interest-rate and currency risk. An individual does not trade swaps in the NSE F&O segment. Futures and options are the products you will meet on the exchange.

An exchange-traded contract has standard terms and trades on a platform such as the NSE or BSE. Prices are visible to everyone, and a clearing corporation stands behind the trades. An over-the-counter (OTC) contract is negotiated privately between two parties, so the terms can be customised but the price is not public and each side carries the other’s credit risk.

In India, individuals trade equity derivatives on the exchanges, regulated by SEBI. OTC derivatives such as interest-rate and currency swaps are largely used by banks and companies, and the Reserve Bank of India oversees those. This is why a retail trader here meets futures and options on the exchange and not swaps.

The table below sets out the practical differences. Rules and permitted products are revised by regulators from time to time, so treat this as a framework for understanding and not as a legal summary.

The idea is very old. Farmers and traders have fixed prices for future delivery for centuries, and organised futures trading in commodities grew in several countries over time. The purpose has stayed the same: to move price risk from someone who does not want it to someone who accepts it.

In India, listed equity derivatives are recent. The NSE launched index futures in June 2000. Index options followed in June 2001, stock options in July 2001, and stock futures in November 2001. The product range then widened over the years, and F&O volumes grew to become a very large part of Indian market activity.

This growth also brought concern. As more individuals began trading these contracts, SEBI studied their outcomes and tightened rules on contract sizes, margins and expiries. The article on SEBI F&O rules in this series covers those changes. For now, remember that these dates show how young the market is, and that the rules keep changing.

Every contract has a specification that tells you exactly what you are trading. For futures it lists the underlying, the lot size, the expiry date and how the contract is settled. An option adds a strike price, whether it is a call or a put, the exercise style and the premium. Read this before you place any order.

Lot size matters because you cannot buy one unit. You trade in lots. The exchange revises lot sizes from time to time. For example, the Nifty 50 lot was 75 and was revised to 65 from the January 2026 expiries. Check the current lot size on NSE before using any example, including the one below.

Notional value tells you how large the exposure is. Multiply the lot size by the price of the underlying. It is not what you pay. You pay margin (for futures) or premium (for a bought option). But the profit or loss on your position follows the notional value, which is why it is the number that matters most for risk.

Take a hypothetical Nifty level of 25,000. This is an illustration, not a live quote. With a lot size of 65, one lot has a notional value of ₹16,25,000. Margin is a good-faith deposit held against your promise to complete the contract, much like a security deposit. The margin set by the exchange and your broker changes with volatility, so the figure used here is only illustrative.

Leverage means controlling a large exposure with a small deposit. Using the hypothetical lot above, suppose the margin is ₹1,75,000. This is illustrative and not a live margin. Against a notional value of ₹16,25,000, that is about 9.3 times leverage. You deposit a small part and take the whole price risk.

This works in both directions. A 1% move in the Nifty from 25,000 is 250 points, or 250 × 65 = ₹16,250. On the illustrative margin, that is about 9.3% gain or loss. A 5% fall is 1,250 points, or ₹81,250, which is about 46% of the margin. The market moved 5%, and nearly half the deposit is gone. Leverage does not improve your chance of being right. It only scales the result.

A long option behaves differently. A buyer who pays ₹9,750 for the hypothetical 25,000 call cannot lose more than ₹9,750, even if the Nifty falls sharply. A futures buyer or an option seller has no such cap. The loss can grow beyond the margin deposited, and the broker can ask for more money or close the position under its rules.

Gap risk makes this worse. Markets can open far from the previous close, and a stop order then fills at the next available price, not at the trigger price. The comparison table shows how each outcome affects the position, using the hypothetical numbers above.

A contract can end in two ways. In cash settlement, no shares or goods change hands. The difference between the contract price and the final settlement price is paid in rupees. In physical settlement, the underlying is actually delivered, so a buyer of a stock future held to expiry receives the shares and must have the money to pay for them.

In India, index derivatives such as Nifty are cash settled, because you cannot deliver an index. Stock derivatives were moved to physical settlement in phases after SEBI’s rules. The exact products, dates and conditions can change, so check the current NSE contract specification for the contract you plan to trade.

Exercise style is a separate point. A European-style option can be exercised only at expiry, while an American-style option can be exercised any time. NSE index options are generally European-style, but confirm the style in the contract specification before you rely on it. In practice, many traders close an option position before expiry by selling it, rather than waiting for exercise.

Companies hedge currency and commodity costs. Funds hedge their portfolios. Market makers provide prices for others to trade. Individual traders mostly speculate. All of these are legitimate uses, but the outcomes are very different.

SEBI studied the results of individual traders in equity F&O for the years FY22 to FY24. It found that roughly nine in ten individual traders lost money over the period. SEBI also reported that the total losses ran into lakhs of crores of rupees, as reported; check the SEBI source for the exact figures. The study counted trading costs, which matter a great deal in a segment with frequent trades.

A follow-up SEBI study for FY25 reported a similar pattern. These figures describe past outcomes for a group. They do not predict what will happen to any one person, and they are not a reason to assume you will be in the minority. They are a reason to understand the risk before you begin.

Source: SEBI, study on profit and loss of individual traders in the equity F&O segment (September 2024), and its later follow-up. Read the original SEBI documents for the exact numbers.

In a private forward, you have to trust the other party. On an exchange, a clearing corporation stands in the middle. Think of a wedding planner holding payments for both families: each side deals with the planner, not with the other family. In India, NSE trades are cleared by NSE Clearing Limited.

This is done through a process called novation. After a trade is matched, the clearing corporation becomes the buyer to every seller and the seller to every buyer. If your counterparty fails, your claim is on the clearing corporation, not on a stranger. To stay safe itself, the clearing corporation collects margin from everyone and marks positions to market daily.

But clearing covers only counterparty default. It does not protect you from market loss. If your position loses money, you still owe it. It also does not remove liquidity risk, system problems or the chance that an exit happens at a worse price than you expected in a fast market.

A hedge can reduce one risk, but it may bring in another. A farmer who sells forward is protected from a price fall but gives up the benefit if prices rise. A hedge also costs money, through premium or margin, and it may not match the exposure perfectly.

Options need extra care. Their value depends on more than direction: the strike, the time left and the expected volatility all matter. A call buyer needs the price to rise past the strike plus the premium paid, and before expiry. A cheap far out-of-the-money option often expires worthless.

The practical lesson is to learn the contract fully, size the position in rupees against your capital, and treat leverage as a risk to manage. The next articles in this series cover futures and options in detail.