Derivatives tend to be popular due to their flexible nature, returns and their ability to give market watchers better predictions for trends of the market. A common underlying feature is that all assets tend to carry the risk of change in their value itself. When traders invest in derivatives they are essentially betting on whether the value of an asset will increase or decrease over a fixed period of time. That is, derivatives are contracts or bets that attain their value from pre-existing or future prices of securities. In derivatives transactions trader is purchasing a promise from the owner of an asset and transferring ownership of an asset rather than the asset itself. The structure of the promise gives traders larger flexibility and in many cases this is what lures investors towards dealing in derivatives. Derivatives and equity shares are two separate entities. That is, equity shares are considered as assets in trade while derivatives attain their value from the assets that the trader owns. There are 4 types of derivatives options, futures, forwards and swaps.
Types of Derivative Traders
There are three categories of traders that deal in the derivatives market– Speculators, Hedgers, and Arbitrageurs.
- Speculators are traders who predict future changes in pricing based on their analysis of the market conditions. These transactions can involve certain amount of risks, which is why speculators tend to be individuals with expertise and experience in forecasting and trade.
- Hedgers are traders that are more cautious by nature, they tend to protect themselves from higher risks by monitoring price fluctuations and selling as soon as they find the price optimum ie. getting a fixed price for stocks. Typically they use futures for protection in order to avoid adverse future pricing and thereby can minimize their risks for holding and interest.
- Arbitrageurs are traders who use market inefficiencies for eg. changes in pricing, dividends, and regulations to make their profits.
Advantages of Derivative Contracts
- Arbitrage Advantage: Arbitrage trading entails purchasing commodities for lower pricing in one market and selling the same for higher pricing in another market. The difference in pricing enables the trader to reap profits.
- Protection Against Market Unpredictability: When there is a price fluctuation of assets, the trader’s probability of experiencing losses also increases. In such cases traders tend to identify products that can act as a shield to protect the price of stocks that he or she owns.
- Park Surplus Funds: Traders can use derivatives as a method to transfer risk. Some may use derivatives for speculation and attaining profits.
Trading in Derivatives Market
- While trading in derivatives, investor needs to deposit a margin amount before beginning a trade. Until the trade between the two parties is complete the margin amount cannot be touched, and the margin amount has to be replenished if it drops below the fixed minimum.
- Traders need to have an active trading account which is being used for derivatives Traders who are using brokers can use phone or online interfaces for trading.
- While choosing entities like stocks, investors need to look at factors such as cash in hand, margin requirements, the price of the contract and the price of shares.
- When the expiration date arrives, traders can choose to either pay the outstanding amount or enter into an opposing trade.
The idea behind derivative contracts is that they are entities traders can use to earn profits by speculating the value of the underlying assets in the future. However while dealing with derivatives traders need to be aware that there is a considerable amount of risk involved. It is recommended that retail investors invest in derivatives only after first ensuring their financial needs and perceive derivatives as a means to diversify their investment portfolio.