Derivative Trading in India : A Detailed Guide for Beginners

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Derivative Trading in India

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With the financial markets getting more and more saturated these days, it has become extremely difficult to find trading opportunities by simply buying and selling stocks, which means that traders have to look at trading derivatives if they are turning a substantial profit.

Derivatives is a financial contract that derive their value from an underlying product like equity, commodity, currency, bonds, interest rates, market indexes. The most commonly used derivative instruments are futures, options, swaps, and warrants. Derivative trading can take place in exchanges like NSE and BSE for stocks and NCDEX and MCX for commodities.


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Most commonly traded Derivative contracts in India

Derivatives have become a highly traded segment of the Indian market since they were introduced in June 2000 by the National Stock Exchange (NSE). Let’s have a look at all the contracts that are used in trading derivatives under NSE:

Derivative Trading
Futures

A futures contract is an obligation to buy a security, stock, commodity or currency at a specified price on a future date. For example, if you buy a crude oil futures contract, you are agreeing to buy or sell a fixed amount of crude oil at a pre-decided price on a future date. 

In this example, you don’t have to take delivery of the underlying asset, rather you make or lose money on whether the contract you bought/sold goes up or down in value relative to the price you bought/sold it for. You can then close out the trade and keep the remains as your profit/loss.

Options

Another form of derivatives very popular among equity traders are options. However, they can be used in other segments as well like for Bonds, commodities etc. and vary in complexity depending on how they are traded.

The simplest way to trade an option is through buying calls and puts. A call option is a right, not an obligation to buy the underlying security at a pre-defined price on a future date. When you buy a call option you are expecting the price of the underlying asset to rise above the strike price of the option before the option expires. If it does you end up making money, if it doesn’t you lose money.

Forwards

A forward contract is an obligation towards a buyer to buy an asset and the seller to sell the asset for a pre-agreed price between the two parties at a future point in time. Forwards don’t trade in high volume in India but the forward OTC market is ever-growing and with more investment, we should see it growing even more.

Swaps

The Swap market exists in India and is completely OTC meaning no exchanges are involved in a Swap transaction. Swaps like based on OIS, LIBOR, MIFOR, Basis spreads have average trading volume and transaction only take place between two parties with a broker acting as a third party in the agreement.

Clearing has already started being centralized. Now all OTC trades have to be reported to the central clearinghouse.

ISDA, the body which governs most OTC transactions all over the world is already in place for most of the Indian companies who engage in such positions. 

ISDA allows two types of agreements:

  • Master : No changes possible to the agreement made under ISDA rules and regulations.
  • Schedule : Changes can be made as per the local laws and regulations and the convenience of the counterparties entering the agreement.

How to trade in derivatives in India?

Nowadays, trading in derivatives has become very simple as compared to earlier mainly due to the internet which has allowed more people to trade derivatives from anywhere.

Most brokers provide their customers with good trading platforms and help them by providing them with charts, indicators and other helpful tools which increase their efficiency and boost their profitability.

Brokers also provide customers with margin facilities so that customers who can borrow from them to make more money while trading derivatives. However, this is a high-risk strategy and one should always be mindful of the risk they are taking before going for margin trading with a broker.

Derivatives are one of the most commonly traded instruments in India and can be either traded through an exchange like BSE or NSE or Over The Counter(OTC). The major difference between the two methods is that for an exchange-traded derivative the rules of the agreement for the derivative are governed by the exchange while in an OTC transaction the rules of the agreement are as per ISDA which is also the governing authority in OTC transactions.

Tax on Derivative Trading in India

Taxation on Derivatives

Income from derivative transactions are taxed as business income irrespective of the volume or turnover. If you’ve traded in derivatives, ITR  (the form for reporting business income) needs to be filled. Even if you’re a salaried person, you’ll still need to fill ITR-4 if you’ve engaged in any F&O trades in the last FY.

Under Section 43(5), a business is categorized as speculative or non-speculative.

  • Speculative business income: Income from intraday equity trading is considered as speculative.
  • Non-speculative business income: Income from trading F&O (both intraday and carryforward) on is considered as non-speculative business. F&O is also considered as non-speculative as these instruments are used for hedging and also for taking/giving delivery of the underlying contract.

Maintenance of Books of accounts

All the transactions carried out need to be recorded. This includes buy/sell transactions, expenses like electricity bills, demat charges, phone bills, advisory fee etc. In case a trader is involved in multiple forms of trading in shares like intraday trading, F&O, making investments in MFs, holding shares for more than twelve months from the date of purchase, the business income from each of these must be declared separately since the tax treatment differs based on the type of dealing. The common expenses can be bifurcated depending on the proportion of time spent on the various types of trades.

Best Brokers for Derivative Trading in India

There are several brokers who provide derivative trading facilities in India but only a few of them are better than the others. 

Here is a list of brokers we think are the best brokers for derivative trading in India based upon factors like good technology, low brokerage etc.

Zerodha

Zerodha provides its customers with state of the art trading software kike Zerodha Pi and Kite which are fast, packed with features like charts and alerts which help you in performing analysis. You can also backtest your strategies using Zerodha Pi.

Apart from technology , Zerodha being a discount broker provides these services at a very low cost with a flat brokerage of Rs. 20 per executed order and also offers margin of upto 3 times for Intraday.

Upstox

Upstox provides its customers with trading platforms like Upstox Pro which is a very fast and feature-rich platform. It also provides attractive brokerage and margin facilities to its customers.

Brokerage charges for Upstox is a flat fee of Rs.20 per executed order. They also provide up to 4 times margin for Intraday trading.

Prostocks

Prostocks is one of upcoming brokers in India and provides a flat fee brokerage structure which is considerably less than its peers. However, it is not known to provide margin to its customers on a big scale.

Prostocks now offers a monthly plan of Rs.899 for unlimited trades in a month which is beneficial for traders and also provides margin of 1.5-2 times for derivatives trading.

5Paisa

5Paisa is known for providing its customers with quality trading platforms like  5paisa Trade Station, Mobile App, and 5paisa trade web-based trading platform. 

They provide a flat brokerage fee plan of Rs10 per executed trade and also offer margin services of 2 times on derivatives trading.

Kotak Securities

Kotak Securities offers trading platforms such as Kotak Security KEAT Pro X, The Kotak Stock Trader Mobile App, and KotakSecurity.com and Xtralite web-based trading platform. They also provide a monthly brokerage plan call the FIT plan which costs Rs. 999 per month.

Here are the details of margin facilities on offer from Kotak Securities: 2x margin on derivatives trading and upto 50 times for other trading types not included in the FIT plan.

Risks of Trading in Derivatives

You should understand that derivatives trading carries an element of risk in it. The following points are self-explanatory.

Derivatives product requires a large number of funds. So it is not for you if you have limited resources. Limited resources mean limited funds and low-risk appetite.

Trading derivatives need expert knowledge. A high trading expertise and experience is mandatory with high-risk tolerance.As a derivatives trader, you must therefore carefully consider its suitability depending upon your financial position.

You should accept the fact that you can lose profits. Even you can incur the loss with the execution of derivatives trade.

Conclusion

Derivatives Trading can be highly risky if not done properly. Those who do derivative trading have expert knowledge of the field and have a lot experience of trading derivatives. However, there is no better time to start trading F&Os than now as the cost for trading securities has gone down and margin has increased which makes more sense for people who are tech- savvy and looking to earn big in the market.

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