What Are Derivatives? Meaning & Types

Start with a worry. Maya runs a burger restaurant. In three months her quarterly profit will arrive, and she plans to spend it on 100 shares of a company she likes. Today those shares cost ₹1,000 each. In three months they may cost more.

She cannot buy now, because the money is not there yet. She cannot stop the price moving. What she can do is find someone who will agree today on the price for that day. That agreement is a derivative.

What she holds is separate from the shares. Its value follows them. The thing it follows is called the underlying. It can be a share, or an index such as NIFTY 50, which tracks 50 large companies listed on the National Stock Exchange of India (NSE).

A forward is a private deal to buy or sell at a set price on a set day, and both sides must go through with it.

Maya finds a shareholder who is happy to sell in three months. They agree: 100 shares, ₹1,000 each, handed over on that day. They wrote the terms themselves, so the deal is private.

Both sides are bound. On the day, Maya pays ₹1,00,000, whatever the shares cost. If the price is ₹1,100, the shares are worth ₹1,10,000 and she is ₹10,000 ahead. If it is ₹900, she still pays ₹1,00,000 for shares worth ₹90,000. The deal does not care. It fixes her price, and it gives up the chance of a cheaper one.

A future is a forward made standard, so it can trade on an exchange.

The exchange fixes the terms for everyone: what the contract follows, how many units, and the expiry, which is the day the contract ends. Because every contract is identical, any buyer can meet any seller.

Two more things change. A clearing house, the exchange’s settlement arm, stands in the middle of each trade, so each side deals with it and not with a stranger. And gains and losses are settled in cash every day. That is called mark-to-market.

Now the same idea on the index. Maya decides she does not need one company. She wants the market itself, so she looks at a NIFTY 50 future at 25,000. We use 50 units to keep the sums round. The real lot, in November 2026, is 65.

Buying a future is called going long. Selling one is going short. An index cannot be delivered, so the future settles in cash. Say Maya goes long at 25,000. If the price rises 250 points, she gains 250 × 50 = ₹12,500. If it falls 250 points, she loses ₹12,500. The seller has the opposite result.

An option gives the buyer a right, not a duty. The buyer pays a fee for it, called the premium.

Say Maya, still watching the market, does not like being bound. She wants to gain if it rises, but she does not want to be forced to buy at 25,000 if it falls. An option gives her that choice.

A call option is the right to buy at a fixed price, called the strike. A put option is the right to sell at the strike. The right lasts until the option’s expiry. After that, it is gone.

Because the buyer gets a choice, the buyer pays for it. The seller receives the premium and accepts the duty: if the buyer uses the right, the seller must go through with it.

Maya buys a NIFTY call with a strike of 25,000. The premium is ₹150 per unit, so for 50 units she pays 150 × 50 = ₹7,500. That is the price of the right.

Because the rise must first pay back the premium.

At expiry, a call is worth something only if the index is above the strike. How much it is worth is its intrinsic value: the index minus the strike, never below zero, times the 50 units.

Say the index finishes at 25,100. That is above 25,000, so the call is worth (25,100 − 25,000) × 50 = ₹5,000. But Maya paid ₹7,500. Her result is ₹5,000 − ₹7,500 = −₹2,500. The index rose, and she still lost.

They differ by what each side promised. Forward and future bind both sides. An option binds only the seller. A swap trades cash flows.

Put Maya’s three agreements side by side and ask one question: who has to go through with it? In a forward, both sides, privately. In a future, both sides, on an exchange. In an option, only the seller. The buyer chooses.

The agreement is far bigger than what you pay. Look again at Maya’s two NIFTY trades: three amounts do three different jobs, and beginners mix them up.

Notional exposure is the size of the position at today’s price, the index level times the units. It is not what you pay.

Margin is money put up as security against an obligation, so the exchange knows daily losses can be paid. We assume 10% of that size. The real figure is set by the exchange and your broker, and it changes. Lesson 37 explains margin.

Premium is the price of an option, per unit times the units. It buys the right and does not come back.

Yes. Margin lets you enter. It does not cap the loss.

The future’s value is ₹12,50,000 and its margin is ₹1,25,000, so the value is ten times the margin. A 1% move in the price, 250 points, is ₹12,500, which is 10% of the margin. That ratio is leverage.

It works in both directions. A 1% rise adds ₹12,500. A 1% fall takes ₹12,500. A 5% fall, to 23,750, takes ₹62,500, half the margin. If the price keeps falling, the exchange asks for more money, and the loss can pass the deposit.

To cancel out a risk, to take one on purpose, or to trade a price gap.

A year on, Maya’s restaurant has done well and she holds ₹10 lakh of shares. A big payment is due soon, and she does not want a fall to land just before it. Her worry is now the opposite of last year’s.

She can hedge: take a position that cancels out part of a risk she already carries. She sells a NIFTY future, so she goes short, and it gains when the index falls. A ₹10 lakh portfolio matches 40 units, because 40 × 25,000 = ₹10,00,000.

Say the index falls 1%, from 25,000 to 24,750, and her shares fall the same 1%. She loses ₹10,000 on the shares. The short future gains 250 × 40 = ₹10,000. The two cancel, before costs.

You close it with an opposite trade, or you hold it to expiry and its settlement rules decide.

Before expiry, you close a position by trading the opposite side in the same contract: sell to close what you bought, buy to close what you sold. Only an executed trade closes it. An order that has not filled leaves the position open.