What is Derivative Trading?

It starts young, doesn’t it? “You think you’re going to win? Okay, I bet 10 bucks you won’t!” Speculating the outcome of what is happening around us is human nature. Indians love speculation, and nothing can attest to this fact more than our constantly buzzing financial markets!

The more risk-averse among us assume markets are like gambling pens where everything depends on luck. Nothing could be further from the truth, but as the maxim goes “No risk, no reward.” Let’s look at derivative trading, a relatively newer concept that has gotten the attention of traders everywhere.

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What is derivative trading?

Simply put, a derivative is a financial security with a value that depends upon or derives from certain underlying assets that could be stocks, currencies, bonds or commodities.

For example – Let’s say an Indian investor purchased shares of a US company through a US exchange. The stock now exposes him to risks related to exchange-rate fluctuations. To hedge this risk, the investor can purchase a currency derivate (like futures) and lock-in a specific exchange rate.

Derivative trading – Types

There are several derivative sub-types, but they largely fall in two categories:

  1. Futures – This form of derivative trading allows an investor to hedge or speculate on the future trends in the prices of an asset. So a farmer can lock in a price on his next harvest by selling a futures contract. This not only eliminates the risk from falling crop prices but also guarantees the amount on the contract even if the crop price goes up due to lower production.
  2. Options – These give you the option to buy or sell an underlying asset like a stock or commodity at a later date, and at an agreed upon price.

Advantages of derivative trading

In today’s highly volatile market, derivative trading provides investors with a form of risk-management that transfers the risk associated with an asset to a party willing to carry that risk.

A few of the benefits:

  1. Hedging your exposure to risk: Since derivatives are linked to the value of underlying assets, these contracts help investors to hedge risks. Once you have a contract, any fluctuation in the value of your asset will not impact the financial outcome for you.
  2. Price determination for assets: In today’s markets, derivatives are largely being used to determine the financial value of assets. The prices fixed on futures contracts provide an excellent approximation of a commodity’s value.

How do I start?

Brokerage firms or registered trading members of any stock exchange can provide you the instruments required for derivative trading. In India, first time investors can only start with a Know Your Customer (KYC) form. Once you receive your client identification number, you can deposit an initial amount of cash to initiate trade.

What should I watch out for?

  1. Be wary of OTC (over-the-counter) derivatives since they carry the risk of being privately negotiated and hence do not go through any exchange. While your returns may seem too good to be true, sometimes that’s exactly what they turn out to be.
  2. Because of the constant changes in markets around the world, it is difficult to predict the value of an asset over a long period of time.
  3. Unlike mutual funds, these require a degree of expertise. Unless you spend significant amount of time understanding derivative trading in your sector, there are chances of you losing big-time on your bets.

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