Derivatives trading

A derivative is a product whose value is derived from the value of underlying assets such as equity, currency, commodity and bonds. These derivative products vary according to their structure and terms and conditions. The most popular derivative products are Forwards, Futures trading, Options, Warrants and Swaps. Derivatives are a hedging (risk mitigation) tool and a high-risk high-return trading option. Recent years have seen an escalating interest in the derivatives market. Trading in derivatives has been popular in developed countries, and is fast gaining momentum in developing economies as well, with the turnover in this segment increasing manifold.

Derivative products include futures and forwards that are contracts to buy or sell an asset in the future at a specified price. Options are contracts that give the owner the right, but not the obligation, to buy or sell an asset on or before the maturity date at a specified price. Swaps are contracts to exchange one security for another on or before the maturity date to take advantage of underlying vales such as currency or commodity rates. Derivative contracts could be privately negotiated or traded on the stock market. Swaps and forward contracts are negotiated between two parties privately and are generally unregulated since information is not made public. Warrants and futures are publicly traded on stock exchanges.

Investment in derivatives could yield large profits if the value of the underlying asset moves in the investor’s favor. Conversely, investors could suffer huge losses if the underlying assets move significantly against them. Derivative strategies help brokers pick the right investments. While trading, the investor needs to keep in mind the expiry date of the contract.

The biggest advantage of derivatives trading is that investors can buy a large amount of stocks and pay only a fraction of the value of the total contract as margins. Investors also have the option to short-sell their stocks, wherein investors sell stocks even before they actually own them. If the investor feels the price of the stock is going to decrease, he could sell his current stocks and then buy some more when the price has reduced. Thus the leverage enables the traders to make a larger profit or loss with a relatively small amount of capital.

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