Trading of derivatives is emerging as a powerful tool for investors, allowing them to buy and sell assets strategically for the future. A derivative is a financial contract that derives value for an underlying asset or benchmark decided by two or more parties.
Derivates have predetermined and fixed expiry dates, offering a compelling alternative to traditional asset acquisition. Derivatives trading can significantly increase gains, making it a popular choice over directly trading underlying assets.
Investors can control substantial quantities of assets with minimal upfront capital in this form of trading. Let us understand what derivatives trading is and how you can benefit from it.
What is a derivative?
A derivative is a financial contract between two or more parties that derives its value from the underlying asset. These assets include indices, stocks, currencies, commodities, exchange rates, or interest rates.
Investors can profit by speculating on the future value of the underlying asset or its movement—up or down—without buying the asset itself. This is why a derivative is called a ‘derivative’ since its value is derived from the underlying asset.
What is derivatives trading?
In this form of trading, investors buy or sell a derivative contract for speculation. Since a derivative contract is ‘deriving’ its value from an underlying market, you can trade on the market's price movements.
Derivatives trading is a leveraged form of trading in which you can buy a large number of underlying assets by paying a relatively smaller amount.
How are derivatives traded?
Now that you have a brief idea of what a derivative is, you might wonder how it is traded. Derivatives can be traded in two ways - over the counter or on exchange.
- Over the counter: In this form of trading, the contract terms are privately negotiated between the parties involved.
- On-exchange: You can also trade derivatives through a regulated exchange that offers standardised contracts. Known as exchange-traded products, they offer the advantage of having the exchange as an intermediary. As the exchange guarantees payment, it largely reduces counterparty risk.
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Types of derivative contracts
Here are some of the most common derivative contracts used in derivatives trading:
- Options are derivative contracts that allow holders to buy or sell an asset at a predetermined price on a future date.
Features:
- Option holders use it to hedge against any potential losses or predict future price movements.
- Investors have the freedom to decide whether to execute the trade based on market conditions.
- It can be applied to various assets such as commodities, stocks, and currencies.
Futures: These are standardised agreements between the buyer and seller to purchase or sell an asset at a predetermined price on a date in the future.
Features:
- Future traders use it to protect against price fluctuations, offering asset insurance.
- These contracts have a set structure, including expiration date and contract size, making it easy to trade on exchanges.
- As it is exchange-traded, futures offer high liquidity and effective price discovery.
Swaps: These contracts adapt according to parties' needs by exchanging cash based on various financial tools.
Features:
- Investors use these contacts to manage and optimise their exposure to different financial threats.
- It involved swapping cash flow with currency swaps, with interest rate swaps being the most common types.
- Parties can tailor swap agreements according to their specific financial circumstances.
Forwards are customised transactions between two parties, curated according to their specific needs.
Features:
- Parties can craft agreements with unique terms. This offers higher flexibility than different exchange-traded counterparts.
- Forwards can be used in various assets like interest rates, commodities, etc.
- As forward contracts don’t need the exchange setting, transactions are confidential between parties.
Risk management strategies in derivatives trading
As a derivatives trader, you might be aware of the potential risks but should also know how to navigate them. Here are some risk management strategies that will make the process easier for you:
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Diversification
If you have ever invested in the stock market, you know the importance of having a diverse portfolio. Investing in various assets can help achieve higher returns with minimal risk. To mitigate potential risks, you can invest in different asset classes like equities, real estate, fixed income, and commodities.
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Hedging
In this process, investors take an offsetting position in a related asset to reduce the price risk of an existing asset position. This reduces volatility risk in derivatives trading. Hedging can be done in the following ways:
- Leveraging derivatives - like forwards or options - to hedge against price fluctuations. This can save investors from huge losses.
- Trading on assets like currencies, gold, or government bonds.
- Pair trading is when a long position is taken in one stock and a short position is taken in another (provided they are correlated).
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Setting limits
You can set a limit to reduce losses. Investors can save their portfolios from major value declines by selling assets when their prices fall below a certain point. You can seize a position by allocating a specific capital amount to a particular investment based on market conditions and risk tolerance.
Summing up
The popularity of derivatives trading is increasing every day due to the high returns it offers. But it does come with its pitfalls. Building an investment plan can help you avoid risks and make more profit.
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Frequently Asked Questions
What are some different risks in derivatives trading?
Some of the risks associated with trading in derivatives are market risk - the risk of a decline in the value of an underlying asset, credit risk - the risk of loss when the counterparty defaults on the obligations and liquidity risk - the risk when derivates are closed at a price before maturity.
Who are margin traders?
A margin in derivatives trading is the starting amount you need to pay the broker. It is a part of the entire value of the investor’s position. This payment feature helps margin traders purchase more stocks than they can afford.
What are some cons of trading derivatives?
Some common disadvantages of derivatives trading are the change in the amount of time until expiration, change in interest rates, or any costs associated with holding the underlying asset. In over-the-counter derivates, counterparty risks can be challenging to predict.
What is a regulatory risk?
Potential changes in rules and regulations can impact trading activities and financial outcomes. In extreme conditions, these conditions can even destroy the company’s business model. This is why creating a trading strategy plan is crucial.
