What Are
Derivatives?
A derivative is a contract whose value is tied to an underlying asset — the foundation behind every futures and options trade on NSE, BSE, and MCX.
The core idea: value derived from something else
A derivative is a financial contract between two parties whose value is determined by — derived from — the price of an underlying asset. You never own the underlying; you own a contract that references it. That contract has a price, it can be bought and sold, and its value moves as the underlying moves.
In Indian markets the underlying can be an index (NIFTY 50, Bank Nifty), a listed stock in the F&O segment, a currency pair (USD/INR), or a commodity (gold, crude oil on MCX). The two most common derivative instruments you will encounter are futures and options — both covered in detail in the rest of this module.
A simple analogy
Imagine a wheat farmer and a flour mill operator. The farmer fears prices will fall by harvest; the mill fears prices will rise. They agree today on a fixed price for delivery three months from now — a forward contract. Neither has sold or bought wheat yet, but the contract itself has value because it locks in a price that diverges from whatever the market eventually does. That is the essence of a derivative: a contract whose worth is derived from a future price.
Financial derivatives work the same way, just with indices, stocks, or commodities instead of wheat, and on regulated exchanges like NSE instead of private deals.
The four main derivative types
- Forwards — private contracts between two parties. Not standardised, not exchange-traded. Credit risk is borne by each party.
- Futures — standardised, exchange-traded forwards. Settlement is guaranteed by the exchange's clearing corporation, removing counterparty risk. See Futures vs Options for how they differ.
- Options — contracts that give the buyer the right, but not the obligation, to buy or sell the underlying at a fixed strike price before or at expiry. The buyer pays a premium; the seller collects it. Learn more in What Are Options?
- Swaps — agreements to exchange cash flows (e.g. fixed vs floating interest rates). These are primarily institutional instruments, not retail-traded on NSE/BSE.
How derivatives are traded in India
NSE's F&O segment is among the largest in the world by volume. Equity index derivatives on NIFTY 50 and Bank Nifty see especially heavy participation from retail traders, institutions, and foreign investors. Contracts are standardised: fixed lot sizes, fixed strike intervals, and fixed expiry dates (weekly on Thursday for major indices, monthly on the last Thursday of the month).
To take a derivative position, your broker requires margin — typically calculated using the SPAN (Standard Portfolio Analysis of Risk) methodology — rather than the full contract value. This creates leverage: a relatively small margin controls a much larger notional position.
SEBI regulates all equity and currency derivatives on NSE and BSE. Commodity derivatives on MCX (Multi Commodity Exchange) also fall under SEBI's purview since the 2015 merger with the Forward Markets Commission.
Why do traders use derivatives?
Derivatives serve three broad purposes:
- Hedging — protecting an existing position. A fund holding a large equity portfolio may sell NIFTY futures to reduce downside during uncertain periods without liquidating stocks.
- Speculation — expressing a directional or volatility view with capital efficiency. A trader who expects NIFTY to rise over the next week can buy NIFTY call options instead of buying all 50 stocks.
- Arbitrage — exploiting price differences between the spot market and the futures/options market, or between different expiries. Arbitrageurs keep markets efficient.
A worked NIFTY example
Suppose NIFTY is near 22,500 (hypothetical). You believe it will rise over the next two weeks. You have two broad options:
- Buy NIFTY futures — you enter a contract for one lot (75 units). Every point NIFTY moves, you gain or lose ₹75. Margin required might be roughly ₹1 lakh, but the notional exposure is 75 × 22,500 = ₹16.875 lakh.
- Buy a NIFTY call option — you pay a premium (say ₹150 per unit × 75 = ₹11,250 total) for the right to benefit from any rise above, say, the 22,600 strike. Your maximum loss is exactly ₹11,250.
Both are derivatives referencing the same underlying (NIFTY), but their risk profiles differ substantially. This is explored further in Futures vs Options.
Lot sizes and expiry — the Indian context
Derivative contracts in India are not traded in single units. Each contract covers a fixed lot size set by the exchange. For NIFTY the current lot size is 75 units; for Bank Nifty it is 35 units (subject to periodic revision by NSE). Multiplying the lot size by the index level gives you the notional contract value.
Contracts expire on a rolling calendar. NIFTY has weekly expiries every Thursday and monthly expiries on the last Thursday. As expiry approaches, time value in options erodes — a concept captured by the Greek theta. Understanding expiry mechanics is covered in Settlement and Expiry.
Common mistakes beginners make with derivatives
- Treating margin as the cost of the trade rather than a deposit — the full notional loss is possible on futures.
- Buying far out-of-the-money options expecting lottery-style returns without understanding how rapidly time value decays.
- Ignoring the role of volatility — option premiums are driven by implied volatility as much as direction. See What is Implied Volatility?
- Not using stop-losses because leverage makes small moves feel insignificant until they are not.
Frequently asked questions
What is a derivative in simple terms?
A derivative is a financial contract whose value is derived from an underlying asset — such as an index (NIFTY, Bank Nifty), a stock, a commodity, or a currency. You are not buying the asset itself; you are entering a contract whose payoff depends on how the asset's price moves.
What underlying assets are available for derivative trading in India?
On NSE and BSE you can trade derivatives on equity indices (NIFTY 50, Bank Nifty, Nifty Midcap Select), individual stocks in the F&O segment, and currencies. MCX offers commodity derivatives on gold, silver, crude oil, natural gas, and agricultural products.
Are derivatives riskier than buying stocks?
Derivatives use leverage, which amplifies both gains and losses relative to the capital deployed. Buying a futures contract controls a full lot (e.g. 75 units of NIFTY) while only paying margin. This makes position-sizing discipline and stop-losses essential. Options buyers have limited downside (premium paid), but sellers face potentially large losses without proper risk management.
Who regulates derivative trading in India?
SEBI (Securities and Exchange Board of India) regulates equity and currency derivatives traded on NSE and BSE. Commodity derivatives on MCX are regulated by SEBI since the merger with FMC in 2015. Brokers are required to collect SPAN + exposure margin from clients before allowing derivative positions.
See derivatives in action
Explore live NIFTY option chain data, open interest, and AI-driven market analysis — free on TradePulse.