Derivatives

Understand what derivatives are, why they exist, how futures and options differ, and the risks of leverage.

A derivative is a contract whose value depends on something else. That something else is the underlying: an asset, an index, an interest rate or some other reference.

Here is the part that matters. You do not need to own the underlying to take a position in a derivative. A contract can let you gain or lose from a change in a price you never held. That is what makes a derivative different from simply buying the thing itself.

This is an educational overview, not financial, tax or legal advice. Derivatives carry a high risk of loss, and the figures below describe what has happened, not what will happen. Verify contract terms with your broker and check with a qualified professional before acting.

This is the introduction. It covers what derivatives are and why they exist. The two instruments this course covers in detail each have their own chapter, and neither is repeated here: futures and options.

Why derivatives exist

Derivatives are not primarily a way for traders to bet without owning anything. They came first as a way to transfer or manage risk, and that is still the reason most people who rely on them use them.

Start with a problem that has nothing to do with trading.

A farmer will harvest wheat in three months. A food manufacturer expects to buy wheat in three months. Both are exposed to the same unknown price, from opposite directions:

Neither can control the price. The farmer cannot stop a bumper crop from being worth less, and the manufacturer cannot stop a poor harvest from raising their costs.

So they agree a price today for a transaction three months from now.

If wheat is ₹2,000 a quintal today and they fix the deal at ₹2,000, both are protected. The farmer sells at a known price even if the market has fallen. The manufacturer buys at a known price even if the market has risen.

This is the idea in its simplest form. A derivative lets you fix a future price today. Two parties who each face a different risk agree to swap that risk, and neither is exposed to the part they wanted to avoid.

An agreement like that is a forward contract: a privately negotiated promise between two named parties. This is an illustration of the economic purpose of derivatives. It is not a claim that every exchange-traded derivative involves someone taking delivery of wheat. Most do not, and what actually happens at the end of a contract depends on that specific contract’s terms, which is covered further down.

Once you have the principle, the rest follows. Instead of one farmer and one manufacturer quietly agreeing a price, standardise the agreement, list it on an exchange, and let anyone trade it. That is a futures contract. Allow the agreement to be an optional right rather than a promise, and that is an option.

The main families

Derivatives come in four broad families.

Futures and options are the two principal exchange-traded derivatives covered in this course. Swaps are a professional market rather than something a beginner meets on a trading screen, and forwards are almost always negotiated privately rather than traded. Both are worth knowing exist.

Nothing above is the whole picture for any one of them. Futures and options cover what you would actually need to trade them.

The words you need

Every derivative is described using the same handful of terms.

Lot size and contract size are easy to confuse, so it is worth being precise. A lot size is a quantity of the underlying, not a count of contracts. If an exchange sets a lot of 1,500 shares, then one contract covers 1,500 shares. Buying three lots means buying three contracts, which covers 4,500 shares. The contract is the thing you place an order for; the lot size is what it contains.

Index contracts work the same way but are worth a separate sentence, because an index is not a pile of things you can hold. An index contract uses a contract multiplier rather than a count of deliverable units, since there is nothing to deliver for an index. That is why the notional is worked out as the multiplier times the index level, and the same reading of the specification sheet applies.

Notional value is contract size multiplied by the price, and it is the figure that tells you how large the position really is. A margin requirement is always smaller than it, which is the whole subject of leverage below.

Strike price appears only where there is a choice of price, which means options. A futures contract has a single agreed price and no strike. Details for each term are in the futures and options chapters.

Futures versus options

The distinction that matters most comes down to one question: who is bound?

A futures contract is a mutual obligation. Both parties are committed, which is why it carries no upfront premium.

An option splits the obligation. The buyer pays a premium for a right and may simply let it expire. The writer collects the premium and takes on the duty of honouring the right if it is used.

That asymmetry is the whole difference, and it explains why volatility affects an option’s price but not a futures price: an option’s value depends partly on how much the price might move, not only where it is now.

One correction to a common assumption, since it causes real surprises: a futures contract does not necessarily result in physical delivery. Settlement depends on the contract, and many settle in cash. Likewise, an option that finishes in the money is generally exercised automatically at expiry, so the holder of a long option cannot assume it will quietly lapse instead. What happens in each case is set by the contract’s rules, covered in futures and options.

Long and short

Long means buying a contract position. Short means selling a contract position. That is the whole definition, and it is not a prediction.

Whether a position profits depends on the direction of the move and on the type of derivative:

• Long futures generally benefit from a rise in the underlying price.
• Short futures generally benefit from a fall.
• Long put options generally benefit from a fall, even though the trader is long the option.

The put example is the one that catches people out. A put gives the buyer the right to sell, so buying one is a long position that benefits when the price falls. Being long or short describes what you did to the contract, not whether you expect a rise or a drop.

Not every short position involves the same margin arrangement as every other, and how a position is margined depends on the product and the exchange’s rules. The mechanics are in futures and options.

Three uses: hedging, speculation, arbitrage

Hedging is using a derivative to reduce exposure to a risk you already carry. The farmer and manufacturer above are the textbook example: each holds an exposure, and the forward cancels the part they do not want. This is where derivatives were invented, and in a hedge the contract is not the point. It is a brake.

Speculation is taking on price exposure in anticipation of future market movements. This is where leverage lives, and where losses concentrate.

Arbitrage is seeking to exploit a pricing difference between related instruments or markets. It is worth being clear that arbitrage is not automatically free of risk: execution costs, funding costs, settlement timing and operational failures all sit between the apparent opportunity and the profit.

Leverage

Contracts represent exposure far larger than the money committed to them, and the gap between the two is leverage. It is also the main reason derivatives lose people money.

A simplified example with round numbers, because the point is the relationship:

• Notional exposure: ₹10,00,000
• Hypothetical initial margin: ₹1,00,000
• Effective notional leverage: 10 times

Read that table with care, because it flatters the position.

• This describes a simplified, linear futures exposure. Real P&L is not a straight line at constant leverage.
• Margin is not the maximum possible loss. It is collateral that supports the position, and losses can go beyond it.
• Additional margin can be demanded well before a 10% adverse move, which is what forces people to sell at the worst possible moment.
• A broker or exchange risk control may close the position earlier than the table suggests.
• Actual margin requirements vary by product and market conditions, and the exchange can change them.
• Transaction costs and other adjustments are excluded from the figures above.

So a futures position does not reliably survive until its entire initial margin is gone. Treat the table as an illustration of scale, not as a map of what will happen.

Expiry

Dated derivatives have contractual expiry dates, and what happens at that date depends on the contract’s settlement rules.

What should not be said is that expiry is the main source of derivatives risk. Significant losses can occur at any time, well before expiry, through leverage and ordinary price moves. Expiry adds a further layer rather than being the layer that causes the damage.

What expiry does introduce is settlement and operational risk, and the consequences differ sharply by how a contract settles:

• A cash-settled contract closes out in money.
• A physically settled contract can create a delivery obligation.
• A futures-devolved commodity contract converts into a position in the underlying, which is explained in commodities.

Most conventional futures and options have specified expiry dates. Forwards and swaps also commonly have agreed maturity or termination dates, although some derivatives can have open-ended or different termination arrangements. The important point is to understand how and when each contract ends, and what obligations remain.

The practical advice is to read the contract specification well before expiry, not on it. The exact expiry calendar is in futures, and the option-specific consequences are in options.

The risks in brief

The detailed risk discussion belongs to each instrument, so this is only the shape of it.

• Leverage and margin call. A small adverse move becomes a large percentage loss against collateral.
• Expiry and settlement. Operational risk concentrated on a particular date, differing by contract type.
• Liquidity. Thin or obscure contracts can be expensive to enter and hard to exit.
• Counterparty and clearing. What stands behind the contract differs between exchange-traded and privately offered products.
• Tax and reporting. Positions can attract tax and reporting obligations that are easy to underestimate.

What the regulator’s data shows

This is covered in full in the reality of trading, which carries seven years of SEBI studies.

The headline, from the study published August 2026 and covering individual traders in the equity derivatives segment only: about nine in ten lost money, and those individual traders recorded aggregate net losses of ₹2.03 lakh crore across FY25 and FY26 combined, exceeding the ₹1.81 lakh crore they had lost across the whole of FY22 to FY24. Those are aggregate outcomes for equity derivatives traders, not figures for commodity or currency markets, and they do not tell you what any particular strategy requires to be profitable.

What it costs and how it is taxed

Costs. Derivatives transactions attract brokerage, exchange fees, statutory levies such as STT and GST, and other charges. In options the premium is small relative to the notional, so per-contract costs bite harder than many people expect. See what it costs.

Tax. The treatment is not uniform. It depends on the type of derivative, the venue, the taxpayer and the law applicable at the time. For eligible transactions in recognised-exchange equity F&O, business-income treatment is generally the relevant regime under Indian tax law rather than capital gains, but that is a summary and not a substitute for the detail, including exceptions. See taxation.

Where derivatives are traded

Derivatives in India exist in more than one setting, and the difference matters.

• Recognised stock exchanges offer standardised equity and index derivatives.
• Recognised exchanges also offer eligible currency and commodity derivatives, and other segments.
• Permitted over-the-counter derivatives also exist, entered into with authorised counterparties under applicable rules. They are not restricted to exchange-traded contracts. See the forex market for how this works in currency.
• Crypto-linked derivatives sold by private platforms are not automatically equivalent to SEBI-regulated exchange-traded F&O. Their regulatory status, custody and investor protections differ substantially. See the crypto market.

The exchanges, their segments and their trading hours are set out in stock exchanges, with currency and commodities covered in their own chapters.

This chapter will not tell you whether a particular derivative offered by a particular offshore platform is lawful for a resident to use. That is a question about a specific contract with a specific counterparty, it is genuinely unsettled, and it needs advice rather than a sentence in an introduction. Be suspicious of anyone who answers it confidently in either direction.

Next: futures.