What are Derivatives?

Investing is one of the best ways to utilise your personal disposable income. However, there are always a range of options in terms of the investment you want to make.

When you first begin investing, it is always best to go with investment tools that offer high security and guaranteed returns. Most of the initial investments people make is centred around a low risk profile. However, as you begin to gain more experience investing and knowledge about the market you are investing in, your risk appetite is also likely to rise, bringing with it the desire to invest in financial instruments that offer higher returns but with lesser security.

Once you have attained that level of experience and knowledge of the market, the most appealing investment instrument to you is likely to be derivatives.

What Is Derivative?

A derivative is a financial contract wherein the investment instrument’s value is derived from an underlying asset or security. An asset or a group of assets are chosen as a benchmark value, from which the derivative’s value is derived.

Essentially a financial contract between two or more parties, the value of the derivative is derived mainly from fluctuations that occur in the price or value of the underlying assets. These assets are usually investment instruments which are commonly traded in the market, such as currencies, commodities, bonds, stocks and the market indices.

Derivative trading happens over-the-counter, or via an exchange. Over-the-counter trading is the more common form of trading derivatives, but since it happens between two private parties, it is not regulated and also more susceptible to the counter-party risk. This risk refers to the possibility or rather the danger of one of the parties involved in the contract, defaulting.

Even as exchange-trade of derivatives remains more standardised and thus safer, for the investor; it has fewer takers since most participants of the derivatives market prefer over-the-counter trading.

If you have understood the meaning of derivatives and what is derivative market, it is obvious that you would also like to understand the advantages of derivative trading and how having derivatives in stock market could be beneficial to you.

Advantages Of Derivatives:

Derivative trading is preferred by experienced investors, owing to several reasons. Read on to learn more about them.

1. Secure Your Investment:

A derivative contract is the best way to protect yourself against an investment that you could be observing turning sour. When you trade in derivatives in the stock market, you are essentially placing money on your certainty that a certain stock will either do well or sink. A large part of derivatives trading is based on speculation and it is essential that your knowledge about the market is adequate enough before you venture into this kind of trading. As a result, if you know that the stocks you have invested in are beginning to drop in value, you could enter into a contract wherein you accurately predict the reduction in the stock value.

2. Advantage Of Arbitrage:

A common trading mechanism among experienced investors is called arbitrage trading, wherein a commodity or security is purchased at a low price in one market and then sold at a significantly higher price in another market. Derivatives trading offers you an advantage in terms of arbitrage trading, which enables you to benefit from the differences in pricing in different markets.

3. Be Protected From Market Volatility:

Investing in derivatives enables you to remain protected from the volatility of the market. For instance, you can buy stocks in a certain market and then enter into a derivatives contract through which you safeguard your investment, even in case you meet with a loss in the market.

4. Profit On Sinking Stocks:

Investing in derivatives often requires you to look at both sides of the picture. As an investor, it is likely that you have invested in stocks that you are confident will perform well. However, if they aren’t and you are able to accurately gauge this before the rest of the market, you could be able to turn a profit by entering into a derivatives contract.

5. Invest Your Surplus Funds:

While most traders enter into the derivatives market in order to speculate and profit, it is also often the best to park any surplus funds you may have. By entering into derivatives contracts with your surplus funds, you are using your funds to generate additional profits without touching any of your existing, underlying securities.

Participants Of Derivatives Market:

Considering the high number of advantages available with derivatives trading, as mentioned above, there are several different participants who enter the derivatives market with their own personal agenda. The definition of these participants changes on the basis of their objective for derivatives trading.

1. Hedgers

Hedgers are among the most risk-averse traders in the entire market. Their major agenda behind investing in derivatives contracts is to secure their own investment, and this is done by them assuming the opposite position to the market. By paying a slight premium, hedgers are able to transfer the risk of losses. This scenario can be better understood through this example. If you hold shares of a company, which are priced at Rs. 120, and you aim to sell these shares in 3 months; you’d ideally not want a fall in market prices to reduce the value of your investment. You also don’t want to risk missing out on a higher price in case the market value goes up. By adopting a hedging position and paying a slight premium, you can ensure that both of your concerns have been taken care of.

2. Speculators

Speculators are the polar opposites of hedgers as they are willing to assume a high amount of risk in order to turn profits. For instance, in the above example, wherein you entered into a derivatives contract to protect yourself against the stocks falling; a speculator will bet that the stock price won’t fall. If in the determined time period, the stock price does not fall; the speculator is able to make a profit.

3. Margin Traders:

Margin traders are those investors who trade on a daily basis and make profits and losses depending entirely upon the day’s market movements. The margin here refers to the minimum amount paid to the broker by the investor in order to enter the derivatives market.

4. Arbitrageurs

Arbitrageurs are those traders who buy securities in one market at a lower price and then sell it for a higher price in another market. They are essentially able to turn a profit through the low-risk market imperfections.

Conclusion

If you have always wondered what is derivative and what is derivative market, it would be fair to assume that you have a better understanding now. Investing in derivatives, like all other investment instruments, requires you to have a thorough understanding of the market and make choices only once you have gained enough knowledge of it. Before you begin trading derivatives in stock market, ensure that you have the prerequisite knowledge to go through with it.