What a derivative is, and why the market for them is so large
The answer
A derivative is a contract whose value comes from the price of something else. That something else is called the underlying — a share, an index, a currency, a barrel of oil, an interest rate. You are not buying the thing. You are buying an agreement about the thing.
Why this costs you money
Here is the part almost nobody is told before their first trade.
When you buy 1 share, the largest amount you can lose is what you paid. The share can go to zero. It cannot go below zero, and nobody will ask you for more money.
A derivative does not work like that. Most derivative positions are controlled with a small deposit rather than the full value of the contract. You put down a fraction and you control the whole. That fraction is the reason a derivative feels cheap, and it is also the reason a derivative can take more from you than you put in.
The concrete version. In India, 1 lot of an index futures contract represents a large notional amount — the index level multiplied by the lot size. You may control that contract with a margin deposit that is a modest percentage of it. If the index moves 2% against you overnight, the loss is 2% of the whole notional, not 2% of your deposit. Against a deposit that is a small share of notional, a 2% move against you can remove a large part of what you deposited.
That is not a rare event. A 2% index move is a normal Tuesday.
The second cost is quieter and it is bigger in total. Derivatives have a deadline. A share has no expiry date, so being early is survivable. A derivative expires on a fixed day, and on that day the contract settles at whatever the price is, whatever you believed. In derivatives, being right at the wrong time is identical to being wrong.
The evidence on what this does to individuals is unusually clear in India. SEBI has published studies of the equity derivatives segment finding that the large majority of individual traders lose money.
How it works
A derivative is a promise between 2 parties about a future price. Every derivative contains the same 4 pieces.
- The underlying. What the contract refers to.
- The size. How much of the underlying 1 contract covers.
- The expiry. The date the promise is settled.
- The terms. What each side must do, and at what price.
There are 4 main families, and the difference between them is entirely about who is obliged to do what.
| Type | Who is obliged | Where it trades |
|---|---|---|
| Forward | Both sides must complete the deal | Privately, between 2 parties |
| Future | Both sides must complete the deal | On an exchange, standardised |
| Option | The buyer may choose; the seller must comply | Exchange or privately |
| Swap | Both sides exchange one stream of payments for another | Mostly privately |
Read the middle column again. It is the whole subject.
In a forward and a future, both sides are locked in. If the price moves, one side gains exactly what the other side loses. Neither side can walk away.
In an option, the obligation is one-sided. The buyer has a right and may decline to use it. The seller has no choice and must perform if asked. Because that is unfair, the buyer pays the seller money at the start. That payment is the premium.
A swap exchanges 2 streams of payments — a floating interest rate for a fixed one, for example. Individuals rarely touch swaps directly. Banks and companies use them constantly.
Why the contract exists at all
Two groups want opposite things, and the contract lets them trade with each other.
A hedger already has the risk and wants less of it. A jeweller who has agreed to deliver gold ornaments in 3 months already owns gold price risk. An airline already owns fuel price risk. An exporter already owns currency risk. None of them created the risk by choice; it came with the business. A derivative lets them hand it to somebody else at a known price today.
A speculator does not have the risk and wants it, because they think they know which way the price will go.
The hedger is buying certainty and pays for it. The speculator is selling certainty and is paid for it. This is the honest description of the market, and it is the reason it exists. Notice which of the 2 you are, before you place an order. Almost every individual reading this is the second one.
Why the numbers are so large
The total notional value of outstanding derivative contracts worldwide is larger than the total value of every listed share on Earth.
That statistic gets quoted to make derivatives sound dangerous or fake. It is neither. It is mostly an artefact of how notional is counted.
If a bank agrees a swap with a customer and then agrees an offsetting swap with another bank, the notional counted is the sum of both, although the bank's actual risk is close to zero. Notional counts the size of the promises, not the money at stake. The money genuinely at risk, called gross market value, is a small fraction of notional.
The real conclusion from the size is different, and more useful. Derivatives are the primary way price risk is moved around the world economy. It is not a sideshow attached to the stock market. For many assets, the derivative market is where the price is actually set, and the cash market follows.
What it tells you, and what it does not
Knowing that something is a derivative tells you 3 things immediately.
- There is a counterparty. Somebody took the other side, deliberately, and they are usually a professional. Ask what they know that makes them content.
- There is an expiry. Time is a term of the contract, not a background condition.
- There is leverage. You control more than you paid.
It does not tell you the instrument is dangerous. A protective put bought against shares you own reduces your risk. A currency forward taken by an exporter reduces their risk. The same instrument that destroys an under-capitalised speculator is what lets a farmer plant a crop.
The instrument is not the risk. The size and the direction of use are the risk. A derivative used to reduce an exposure you already have is insurance. A derivative used to create an exposure you did not have is a bet with a deadline.
The decision rule
Before any derivative trade, answer 3 questions in writing. If you cannot answer all 3 in one sentence each, you do not have a trade.
- What am I exposed to that I was not exposed to before? Name the
underlying and the direction.
- What is the largest amount I can lose, including the case where the
market gaps overnight and I cannot exit? Not the margin. The loss.
- Who is on the other side, and why are they happy to be there?
If the answer to question 1 is "nothing new — this reduces a risk I already had", you are hedging. If it is "a new exposure", you are speculating. Both are legitimate. Confusing one for the other is not.
Try this now
Five minutes. This is the single number that explains why derivative accounts change quickly, and most people who trade them have never calculated it.
- Open your broker app and go to the derivatives or F&O section. Choose the nearest expiry of the main index future in your market.
- Write down the lot size — the number of index units in 1 contract. It is shown on the contract page.
- Multiply the current index level by the lot size. That is the notional value of 1 contract. It is the amount of market exposure you are taking.
- Now find the margin required to buy 1 lot. Most apps show this on the order screen before you confirm, and every broker publishes a margin calculator.
- Divide the notional value by the margin required. That is your leverage.
What you should see. A number well above 1 — commonly between about 5 and 10 for index futures, and larger for some contracts.
Now do the part that matters. Multiply the notional value by 2%. That is what a single ordinary 2% day costs or earns you. Compare it with your margin. Then multiply the notional by 5% and compare that with your total account value, not your margin.
If a 5% move in the underlying is a large share of everything you own, the position is too big. You have just learned that before placing it rather than after.
Three real cases
1. Barings Bank, 26 February 1995 — a derivative position without a limit Nick Leeson, a trader in Singapore, built very large positions in Nikkei 225 futures and sold options against them, hidden in an unreconciled account. The Kobe earthquake on 17 January 1995 moved the Japanese market against him. Losses reached roughly £827 million, more than the bank's capital, and Barings — 233 years old — was sold for £1. Nothing about the instruments was exotic. The position was simply larger than the institution could survive.
2. WTI crude oil, 20 April 2020 — the contract is not the commodity The May 2020 West Texas Intermediate futures contract settled at about minus $37.63 per barrel on the day before it expired. The price of oil went below zero. This was possible because the contract requires physical delivery at Cushing, Oklahoma, storage there was full, and holders who could not take delivery had to pay somebody to take the contract off them. CME Group had changed its systems days earlier to permit negative prices. Retail products exposed to that contract suffered severe losses, including a structured product sold by Bank of China to individual investors.
The lesson is exact: a futures contract is a promise about delivery, not a holding of the commodity, and the difference only becomes visible at expiry.
3. India's equity derivatives segment, 2019 onwards — the largest natural experiment available Indian index options grew to account for an extraordinary share of global derivative contract volume, driven mostly by very short-dated index options bought and sold by individuals. SEBI responded with a package of measures in October 2024, including a higher minimum contract value and fewer weekly expiries per exchange. This is not history from another country. It is a regulator measuring the outcomes of people exactly like the reader, and acting on what it found.
The question that resolves it
A novice asks: how much can I control with this money?
An expert asks: how much can this control cost me, and on which day?
Those are the same arithmetic read in opposite directions. The first question produces the position size. The second question produces the position size that survives.
What would make this wrong
If leverage were the only issue, then any derivative position taken at 1 times leverage would be as safe as owning the underlying. That is nearly true for a future and clearly false for a sold option, because a sold option's loss is not proportional to the position's notional in the same way.
Three honest limits on this article.
"Derivatives are dangerous" is a lazy conclusion. Insurance is a derivative in every meaningful sense. So is a fixed-rate home loan from the bank's point of view. Blanket avoidance costs businesses money every year.
Notional value is a poor measure of risk. The very large global figures overstate exposure badly, because offsetting contracts are counted twice. Anybody using the notional number to argue that the financial system is a bubble is misreading a statistic.
Not every derivative is leveraged the same way. A fully cash-covered option position, or a hedge sized exactly against holdings you own, carries very different risk from the same contract taken naked. The contract type does not determine the risk. The position does.
In India
Exchange-traded derivatives in India trade mainly on the NSE, with a growing segment on the BSE, and commodities on the MCX. The main contracts individuals meet are index futures and index options on the Nifty 50, the Bank Nifty and the Sensex, and single-stock futures and options on a restricted list of companies.
Five features matter and none of them exist in the same form elsewhere.
Lot sizes, not shares. You cannot buy a fraction of a contract. The smallest position available is 1 lot, and SEBI raised the minimum contract value for index derivatives in its October 2024 measures. The practical consequence: a small account cannot take a correctly sized position, and rounding up to 1 lot silently multiplies the intended risk.
Index derivatives are cash-settled. Nobody delivers the Nifty. At expiry, the difference is paid in cash. Single-stock futures and options, by contrast, are physically settled — shares actually change hands.
Securities Transaction Tax applies at several points, including on the sale of options as a percentage of premium, on futures as a percentage of the sale value, and on exercised options as a percentage of intrinsic value. The exercise charge in particular has produced unpleasant surprises, covered in a later article in this cluster.
Margins are collected upfront and marked to market daily. SPAN margin covers the modelled risk of the portfolio; exposure margin sits on top. Losses are settled in cash every day, not at expiry, so a position that is eventually correct can still require money you do not have on the way there.
Weekly expiries concentrate activity. For years, an expiry occurred on most trading days of the week across products and exchanges. SEBI's 2024 measures limited each exchange to one weekly index expiry.
In the United States
American derivatives split across 2 regulators. The SEC oversees options on shares and equity indices; the CFTC oversees futures and options on futures. The main venues are the CME Group for futures, and Cboe, Nasdaq and NYSE options markets for equity options, with all listed equity options cleared through a single clearing house, the Options Clearing Corporation.
Four features differ meaningfully from India.
Standard contract size is 100 shares. An option on a $40 share represents $4,000 of underlying. Combined with a low or zero commission, this makes small positions genuinely available in a way Indian lot sizes do not.
Equity options are physically settled and American-style, meaning the holder may exercise on any business day up to expiry, not only at the end. Broad index options such as those on the S&P 500 are cash-settled and European-style, exercisable only at expiry.
Margin follows Regulation T for retail accounts, with portfolio margin available to larger accounts. Futures margins are set by the exchange as a performance bond and are typically a small percentage of notional.
There is no transaction tax on options comparable to STT. There is a small SEC fee on sales and exchange fees, but the tax layer that shapes Indian strategy economics is absent.
Where they differ, and what that tells you
Settlement. India cash-settles its index contracts, so a position that expires in the money simply produces a cash difference. The United States physically settles single-stock options, so an American who forgets an expiring in-the-money call can wake up owning 100 shares they did not intend to buy, with the cash demanded on Monday. Each system produces its own characteristic accident. The Indian accident is a tax charge on a contract you thought was worthless. The American accident is a delivery obligation.
Size. The American contract on 100 shares of an ordinary company is small enough that a beginner can take a position that cannot hurt them badly. The Indian minimum contract value means the smallest available position is large relative to most retail accounts. This is the most under-discussed difference between the 2 markets, and it works against Indian beginners specifically. American advice about "starting small to learn" is not directly executable in India, and the honest Indian version of that advice is: paper-trade or do not trade.
What the regulator has measured. No American regulator publishes anything resembling SEBI's population-scale studies of individual derivative traders. Indian readers therefore have better evidence about themselves than any other market's participants have about theirs, and are the least likely to have read it.
Carry this
- A derivative takes its value from something else, and always has a counterparty, an expiry and leverage.
- Hedging removes a risk you already had. Speculating creates one you did not. Know which you are doing before you order.
- A share can wait for you to be right. A contract with an expiry date cannot.
- The margin is not the risk. The notional is.
Knowledge check
Related
- Futures and forwards: locking in tomorrow's price today
- What an options contract is: calls and puts
- Buying options compared with writing options
- Risk management and position sizing
- ← Options and derivatives