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What is Derivatives Trading?

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The Term Derivatives trading seems complex, but in simple terms it is a contract between entities. The worth of this contract is based on a financial instrument underlying the contract, hence it is ‘derived’ from the base asset. The base product may be a share, a bond a commodity, or an index etc. Derivatives trading can also be understood as secondary instrument derived an underlying financial asset’s value.

Derivatives seem to be too risky and sophisticated for an unexperienced investor. The fact is that derivatives can actually act as a safeguard or insurance to protect against volatility of a share, portfolio or index.

Let’s take example of a farmer who anticipates that the price of his produce will fall in future. The price right now is Rs 100 per kg. To not lose money at a later date, he gets into a contract to sell the produce at a future date at Rs 100 per kg. The buyer on the other hand believes prices will go up and therefore agree to pay Rs 100 at future date in anticipation of profit. The contrarian view of the two parties, one will be wrong and create a hedge and profit opportunity.

There are various types of derivatives. Broadly they are categorised into options, swaps, futures, and forward contracts.

Swaps, futures, forwards oblige the parties to the terms till the end of the contract.

Option products provide the option to the buyer to enter the transaction agreed in the contract, but it is not an obligation.

Derivatives are bought and sold through an exchange as well as directly between parties.

Advantages of trading in derivatives:

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Low costs: Derivatives are a risk management tool. The processing cost is low compared to other segments and asset class. In derivatives trade, there is no actual buying or selling of the instrument on which derivatives is based. The trade is done on the value alone.

Risk Hedge: Derivatives are an excellent tool to cover risk. This is the biggest benefit why investors trade in derivatives. The derivatives contract covers the risk due to movement in price of base security and limits the loss.

For example, in a forward contract, a buyer and seller enter into an agreement to execute the buy or sell at a future date at a pre-decided price. Therefore, the risk due to volatility in price of base security is limited.

Risk Transfer: Derivatives transfer the risk inherent in an underlying security from the buyer to the seller. Effectively, the parties exchange the risk based on differing view on the value of security. The risk appetite of one investor differs from other. Through Derivatives Contract, risk shifts from participant who wants low risk to the one who wants to take higher risk.

Market efficiency: Derivatives bring better market efficiency. Derivative contracts are based on expectations of profit on underlying securities. This brings an equilibrium in the expected price movement of a security and its actual movement, thus reducing the arbitrage and makes the markets more efficient

Derivatives also help in discovering the price of the base security. The spot rate in a contract gives an indication of the current price of the security. Derivatives help in understanding the price movements. Derivatives also help in predicting uncertain future events that impact the spot and future price of a security, e.g. debt default.

Speculation: Derivatives trading is considered risky and complex due to its speculative nature. The same feature is also an advantage if executed with reason. At times, derivatives are used for speculative trading, assuming that other party’s view is wrong about the price of base instrument in future. The price fluctuations provide an opportunity to speculate and earn profit.

Derivatives provide often allow investors to trade in assets which otherwise are not traded in open markets.

Yes, derivatives trading is more cost effective compared to other segments and asset classes.

FAQs on Derivatives Trading:

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Derivatives cover the risk in base security from abrupt market fluctuations. Derivatives also shift the risk to the other party and provide insurance against volatility.

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Derivatives also help markets to assess/discover the price of base instrument, now and in future. Derivatives markets run almost in similar patterns to the actual price movement of the security. Derivatives thus bring market efficiency and equilibrium.

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Yes, Derivatives trading is profitable because investor need not buy the base security but can take a view on it’s future price and thereby earn a profit without actually buying the base security.

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Let’s say that you hold shares of a company whose share price is Rs 500 right now. The company is performing well and you have confidence in the value. You expect an expense and would like to sell these shares in three months. The market is highly volatile and you fear that the price of the share may fall in three months. However, there is a possibility of share price going up further and you so not want to sell it right now and lose the appreciation.

You have a price goal of minimum Rs 480 from the stock if the market falls in three months. Also, if the price goes up beyond Rs 500, you want to reap the appreciation. Thus you can pay a small price, and buy an 'option' that incorporates all your above requirements. Hence you hedge your risk and reduce your losses if price falls. Thus you are insuring your risk and transferring it to the other party willing to take these risks.

You can buy derivatives to cover your risk in overall investment portfolio or to hedge the uncertainty created by volatility in market. It requires proper information and know-how to deal in derivatives trades. To grow your portfolio, protect against uncertain risks and benefit from price speculation, contact us at_ _ _ _

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