Derivatives: Types, Advantages, Disadvantages, How to trade Derivatives

Investing is considered the best option to build your wealth in the long term. There are various financial instruments that you can invest in such as shares, derivatives, bonds, etc. present in the market. Depending on your risk tolerance and profit expectations, you can choose your investment option. Also, investing requires some level of experience and understanding of the market. This helps you in investing in financial instruments such as derivatives. Let us understand ‘What is a derivative?’, types of derivatives, advantages and disadvantages of derivatives, and more in detail. Keep Reading!

What Is a Derivative?

Derivatives are financial contracts between two or more parties that derive value from an underlying asset or set of assets. These assets could be stocks, currencies, commodities, indices, exchange rates, or the rate of interest. Depending on the market conditions, the value of the underlying assets changes. By betting on the future value of the underlying asset, you can make profits using these financial instruments.

Derivative trade can happen over the counter (OTC) or formal exchange markets. Over-the-counter derivatives are not regulated by a central authority where two parties are involved offering more flexibility and customization. Exchange-traded derivatives are standardized contracts providing transparency and accessibility to a broader market.

Types of Derivatives

The following are types of derivatives that you can invest in:

Futures Contract

Futures Contract is an obligatory contract between the buyer and seller of an underlying asset. It means both buyer and seller must honour the contract. On the contract execution date, the buyer decides to buy an asset at a predetermined price and the seller agrees to sell the asset.

Options Contract

It is a non-obligatory contract between the buyer and seller of an underlying asset. It means both buyer and seller can exit the contract at any time. The specified price agreed by both parties is referred to as the strike price. The option seller is also known as the option writer.

Forwards Contract

Similar to a futures contract, it is an obligatory contract between the buyer and seller of an underlying asset. Forwards are not traded on stock exchanges and are unstandardized, unlike futures and options. Through over-the-counter deals, investors can buy forwards. Also, both parties can customize the forwards contract.

Swaps Contract

Swaps happen through over-the-counter deals between financial institutions and businesses. The cash flow depends on a notional principal amount and not a real principal. Generally, swaps take place in the currency segment of stock exchanges.

Types of Exchanges- Traded Derivatives

Following are the types of exchanges-traded derivatives:

Stock or Equity Derivatives

Financial instruments like stock or equity derivatives derive their value from underlying assets like stocks, bonds, commodities, or currencies.

Currency Derivatives

Currency derivatives also known as financial contracts derive their value from the underlying assets of a foreign currency.

Index Derivatives

Financial contracts that are based on an index's performance are Index derivatives. Futures, options, and swaps are the most common types of index derivatives. 

Interest rate Derivatives

Interest rate derivatives are used by both institutional and individual investors to hedge their exposure to interest rate movements. The most popular rate derivatives are Futures, forward contracts, swap agreements, options, and caps and floors.

Advantages of Derivatives

• Derivatives are the best option for reducing risk in the investment. For risk management, derivatives act as insurance policies
• As compared to shares, bonds, or other securities trading in the derivatives market requires low transaction costs. They guarantee low-cost transactions since derivatives serve as risk management tools.

Disadvantages of Derivatives

·    Derivatives have higher risk as the value is derived from underlying assets. The prices of these underlying assets have high volatility and unpredictability. Any price movements in these assets can impact these contracts.

·       To gain profits, derivatives require to use of speculation. The market is unpredictable, leading to higher risk and can cause massive losses.

How to Trade Derivatives?

By following the below-mentioned steps, you can trade derivatives:

• Step 1: Open an online trading account. You can take orders over the phone or online if you are trading derivatives through a broker.
• Step 2: Pay a margin amount. You cannot withdraw until the end of the contract and the trade is concluded. Suppose, while trading your margin goes below the minimum permissible amount, you will get a margin call to rebalance it.
• Step 3: Keep your budget in mind, sufficient to cover margin for trading, available cash, and contract prices. Alongside, you must ensure that you are aware of underlying assets to avoid any financial inconvenience.
• Step 4: Stay invested until the trade is resolved.
• You must stay invested, be consistent, and make informed decisions to reach your financial goal.

Who can participate in the Derivatives market?

Hedgers

Hedgers enter into a derivative contract to mitigate their risk exposure. They are the producer, manufacturers, etc., of the underlying asset. Even if the prices go down in the future, hedgers ensure that they will get a predetermined price for their assets. 

Speculators

Speculators are actual traders who try to predict the future price of commodities based on various factors and monitor their prices regularly. Suppose, the speculators think that the price will go up for a particular asset, they buy a derivatives contract for that asset and sell at the time of expiry to make a profit.

Margin traders

Depending entirely upon the day’s market movement, margin traders trade daily. These market traders do not use their own money to buy and sell but borrow the amount as a margin from the stockbroker. The minimum amount paid to the broker by the investors to enter the derivatives market is referred to as the margin.

Arbitrageurs

Traders who buy securities in one market at a lower price and sell them for a higher price in another market are Arbitrageurs.