Derivatives are kind of financial contracts which attain their value from an underlying instrument. These underlying instruments could be currencies, stocks, commodities, indices, rate of interest or exchange rate. From the past few years, the derivatives market has seen extraordinary growth in it.
In this period of time, many derivatives contracts were released at exchanges all around the world. The reason behind this phenomenal growth was primarily due to raised movements in the price of underlying assets, increased understanding of market player, the inclusion of financial markets globally, continuous modernisation in the derivatives market and advanced risk management tools to handle the risks.
Types of Derivative Products
1. Forwards
Forwards are contractual agreements between two or more parties to buy and sell an underlying instrument at a specific date in future and on a fixed price which is predetermined when the contract is made. Both the buyer and seller parties are committed and obliged to respect the transaction no matter what the price of underlying instruments at the time of contract expiry. The terms and conditions of Forward Contracts are customised because these are negotiated between both parties. Forwards contracts also known as over the counter (OTC) contracts.
2. Futures
Futures are also contracts same as forwards. But the only difference between them is the transaction which is made through a regulated and organised exchange without any negotiations between the parties.
3. Options
The option provides the right, but it is not an obligation. It provides the right to buy and sell the underlying asset on or prior to the specified date and at a fixed price. Meanwhile, the buyer of the option pays out the premium and purchases the right of option. And the seller or writer of option accepts the premium with an obligation to buy/sell the underlying instrument if the buyer uses his right.
4. Swaps
Swaps is also an agreement between two parties to interchange cash does in the upcoming future according to a predetermined formula. It helps market players to handle the risk liked with volatile currency exchange rates and in interest rates.
How to trade in Derivatives Market
1. Do Your Research
Research is more essential for the derivative market. A trader can invest in derivatives trading only in available derivatives contracts. There is a fixed expiry date, so the traders need to exit the market before the derivative contract expires; otherwise, it will auto settle on the expiry date. ANd this settlement could be in favour of the investors and have an equal possibility of not in favour of an investor. That is why the derivatives market needs more accurate, exact and time-bound view comparative to the purchasing stocks in delivery.
2. Arrange the Necessary Margin Amount
Derivatives contracts are started by paying out a small amount of margin and needs extra margin in the hand of traders according to the share movement. Remember one more thing that the margin amount fluctuates according to the price of the underlying share falls or rise. That is why it is wise to keep some extra money in your trading account.
Why use Derivatives
Leverage
Because it needs some percentage of margins compared to the whole value of trade.
Liquidity
Derivatives are more liquid due to their low-cost nature and leverage. The higher will be the liquidity, the lower will be the effect on trades.
Hedging
An investor can avail hedging to shield against short term movements in the prices.
Bottom Line
Investors mostly utilise derivatives for main three reasons: first one to hedge a position, second to take the benefit of high leverage and the third reason is to speculate on instruments fluctuations.
