Different Types of Derivatives

There are four major types of financial derivatives, and you can read all about them below. Make sure to identify the type of derivative that works best for you before you go ahead with the investment.

1. Options

While the financial value of derivative securities is based on the value of the underlying asset, an option is a contract wherein the buyer attains the right to trade the underlying asset over a predetermined period of time. The price that has been determined by both parties is known as the strike price, and the seller of the option is called the option writer. The buyer however, is not obliged to exercise the option for trading in the underlying assets, wherein he can choose to either buy or sell the asset, or do nothing.

2. Futures

Among the different types of derivatives, futures are the most stringent since it imposes an obligation upon the parties entering into the contract to execute it as well. A price and date are agreed upon, which the parties must execute the contract. While derivatives and its types can be traded either over-the-counter or through an exchange, futures are standardised owing to them being traded via the exchange. Owing to this, futures contracts carry no credit risk at all since the clearing house acts as a counter-party to the trade.

Also Read Difference between Options and Futures

3. Forwards

Forwards are similar to futures in the manner of trading, since a forwards contract also comes with an obligation to execute the contract. However, unlike futures, forwards are traded over-the-counter instead of through an exchange. Forwards also offer the contracting parties the option to customize the contract as per their own requirements.

4. Swaps

These over-the-counter contracts enable parties to swap their financial obligations, among which interest rate swaps are the most common. The cash flows within this contract are based on a rate of interest, and while one cash flow is generally fixed, the other is susceptible to change as per a benchmark interest rate.

How To Trade In The Derivatives Market

Now that you know about the different types of derivative securities, it is important to understand how you can trade in them successfully in order to turn a profit. There are several reasons why trading in different types of financial derivatives differs from the trade that happens in the stock market, and it is essential that you are aware of these before you begin trading.

• The first thing you are required to do when you start trading in derivatives and its types is that you need to pay a marginal amount, which cannot be withdrawn by you until the contract is executed and the trade has been settled. If, while trading, your deposit falls below the minimal acceptable amount, you are required to replenish it. Many traders, known as margin traders, participate in the trading of derivatives only to make profits from the margins of their purchase and sale.
• An online trading account also needs to be created before you can begin trading in different types of derivatives. However, if you are using the services of a broker for trading in this market, you can place your orders over the phone or even online.
• The most important thing to understand before you begin investing in different financial derivatives is the market itself. It is necessary for you to thoroughly educate yourself regarding the current market conditions and the factors that are likely to impact it. Any financial market is dependent upon factors which include economic, political and social developments. Any of these things is enough to cause a significant shift in the market and it is essential that you are not just aware of these developments, but also prepare for them in advance. A large part of trading involves preemptively making decisions on the outcome of the market and preparing for it well in advance.
• Before you invest into a particular derivative, make sure to thoroughly understand everything about the underlying asset it is based on. Keep your budget in mind and ensure that it is adequate for meeting the financial requirements of the margin for trading, cash in hand, and prices of the contract and the underlying asset as well.
• While you are investing, it is best that you remain invested in the contract until the trade has been settled.

Derivatives and its types are a great tool for experienced investors who want to park their surplus funds into generating a profit, and are also popular with hedgers who are extremely risk-averse. It is a fast-changing market and investment experience and market knowledge are prerequisites that cannot be done without if you want to invest in these types of contracts.