There are a lot of ways in which you can earn money in the stock market either in the cash market or in the derivatives market. There are various trading instruments that you can use to achieve different financial goals based on your risk appetite and the duration you wish to stay invested for. One can express their views in the market by trading both via the cash market and the Derivatives market. In this article, we will learn about the difference between the cash market and the derivative market.
What Is A Cash Market?
Also known as the spot market, securities and commodities like shares and bonds of precious metals, agricultural produce, etc. are traded for immediate delivery. There are 2 sections in this market; debt and equities.
The cash market is regulated by SEBI. One can trade in the cash market through the Bombay Stock Exchange and National Stock Exchange.
It’s a place where the buying and selling of commodities are mutual and is undertaken by the government, the general public, other companies, fund houses, AMCs, etc.
The cash market price is the current quote for immediate purchase, payment, and delivery of a particular security. This is incredibly important since prices in derivatives markets, such as futures and options, will inevitably be based on these values.
What Is The Derivatives Market?
The derivatives market is the financial market for financial instruments like futures and options. The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark.
A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC). The market can be divided into two: Exchange-traded derivatives and over-the-counter (OTC) derivatives.
The legal nature of these products is very different, as well as the way they are traded, though many market participants are active in both.
Participants In The Derivatives Market
The participants in the derivatives market can be broadly categorized into the following four groups:
1. Hedgers
Hedging is when a person invests in financial markets to reduce the risk of price volatility in exchange markets, i.e., eliminate the risk of future price movements.
Derivatives are the most popular instruments in the sphere of hedging. It is because derivatives are effective in offsetting risk with their respective underlying assets.
2. Speculators
Speculation is the most common market activity that participants of a financial market take part in. It is a risky activity that traders engage in.
The speculation involves trading a financial instrument involving high risk, in expectation of significant returns. The motive is to take maximum advantage of fluctuations in the market.
Speculators are prevalent in markets where price movements of securities are highly frequent and volatile. They play very important roles in the markets by absorbing excess risk and providing much-needed liquidity in the market by buying and selling when other investors don’t participate.
3. Arbitrageurs
An arbitrageur is a type of investor who attempts to profit from market inefficiencies. These inefficiencies can relate to any aspect of the market, whether it is price, dividends, or regulation.
Arbitrageurs exploit price inefficiencies by making simultaneous trades that offset each other to capture risk-free profits. An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than
one exchange by buying the undervalued shares on one exchange while short-selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.
4. Margin Traders
Margin traders are speculators looking to make a quick profit from movements in prices by leveraging beyond what their current financial capacity permits.
Margin traders ensure that they don’t miss out on any trading opportunity due to the paucity of funds. What the Margin traders do is use the margin account as a leverage machine to enhance the size of trades where conviction is high.
Types Of Derivative Contracts
Derivative contracts can be classified into the following four types:
1. Options
Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (referred to as the strike price) during a specific period of time.
In India options have a weekly expiry and these weekly contracts expire every Thursday of the week.
2. Futures
Futures contracts are standardized contracts that allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date.
The parties involved in a futures contract not only possess the right but also are under the obligation, to carry out the contract as agreed. The contracts are standardized, meaning they are traded on the exchange market.
3. Forwards
Forwards contracts are similar to futures contracts in the sense that the holder of the contract possesses not only the right but is also under the obligation to carry out the contract as agreed. However, forward contracts
are over-the-counter products, which means they are not regulated and are not bound by specific trading rules and regulations.
Since such contracts are unstandardized, they are traded over the counter and not on the exchange market. As the contracts are not bound by a regulatory body’s rules and regulations, they are customizable to suit the requirements of both parties involved.
4. Swaps
Swaps are derivative contracts that involve two holders, or parties to the contract, to exchange financial obligations. Interest rate swaps are the most common swaps contracts entered into by investors.
Swaps are not traded on the exchange market. They are traded over the counter, because of the need for swap contracts to be customizable to suit the needs and requirements of both parties involved.
Difference Between Cash Market And Derivative Market
| Category | Cash Market | Derivatives Market |
| Lot sizes | In cash markets, investors can buy or sell in any quantity. Even 1 share can be traded. | In derivatives markets, the lot sizes are fixed and single shares are not available. Lots are to be traded. |
| Nature of assets | Cash market trade only in tangible assets | Derivatives markets can be used to trade in tangible or intangible assets. For eg: futures and options |
| Dividends | In cash markets, the investors have the right to dividends | In derivative markets, investors have no rights to the dividends |
| Ownership | Investors have ownership of the asset (share) purchased by them | Investors do not have any ownership of the asset purchased by them |
| Holding period | When you buy shares in the cash segment, you can hold the shares for life. In fact, when you buy shares in the cash segment they can also be trans-generational, that is they can be transferred from one generation to the other. | This is not true in the case of the derivatives market, where you have to settle the contract within three months at the maximum. |
Also Read: What Are The Differences Between Shares And Debentures?
In Closing
Derivatives are an attractive investment option for many traders with a high-risk appetite. It allows them to hedge their risk and gain the benefits of arbitrage.
However, it is a high-risk game and the investors who do not take calculated risks or over-expose themselves can end up in the deep end and lose all their capital along the way.
Hence it is advisable to have a good knowledge of these markets before plunging into them whereas if investors are looking to invest in security for the long term then the cash markets are perfect for them and the level of risk is lower in cash markets.
That’s all for the article on the Difference Between Cash Market And Derivative Market, We hope you enjoyed reading it. Happy Investing!
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