Trading in the financial market gives numerous options on how wealth is gained, and the derivative considered as the ultimate tool of all time. Its value mainly comes from another asset: these could be stocks, bonds, commodities, or even different currencies. The derivatives represent many opportunities, but also comes with risks on their own terms. In this blog, we will read about the derivatives advantages and risks into our trading portfolio.
What are Derivatives?
Derivatives are finance agreements and their value is linked to the underlyying assets. Derivatives come in several types, for example, futures, options, forwards, and swaps. Derivatives can be used for a number of reasons such as for hedging against price fluctuations, attempting to forecast future price movements, or for arbitrage on price differences.
Advantages of Trading Derivatives
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Risk Management (Hedging)
One of the essential functions of derivatives is managing risk. If you are affected by a certain asset, you can use derivatives to hedge against adverse changes in price on that asset.
Example:
Just imagine you are a farmer hoping to collect 1,000 tons of wheat within six months; in this case, you are concerned that the price of wheat may decline before selling. By selling wheat on future contract at certain price, you can protect your revenue and avoid losing money if the price is declined.
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Leverage
Derivatives enable a trader to handle a large position with just small money. It is termed leverage.
Example:
Assume you believe that the stock of Company X trading at ₹100 a share would move higher. So, rather than buying 1,000 shares for ₹1,00,000, you could buy call options on it for an inconsequential fraction of that amount and on to the same upside.
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Price Discovery
The derivatives markets help in finding prices more efficiently. The trading in the futures and options market reveals what all these market participants believe will happen to prices in the future.
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Market Efficiency
Derivatives help resolve the price differences between markets by enabling individuals to exploit arbitrage opportunities, thereby making the market work better overall.
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Access to hard-to-reach markets
Derivatives can open access to assets or markets that may be difficult to invest in directly.
Example:
If you want to invest in things like oil or precious metals but don't want to own them physically, you can invest in commodity futures or options.
Risk of Trading Derivatives
Derivatives carry major benefits, but they also pose serious risks, and it is what you should be aware of.
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Leverage Risk
Leverage has both good and bad sides. It can increase your profits, but it can also make your losses bigger.
Example:
If you invest ₹10,000 in a futures contract that controls assets worth ₹1,00,000, a 10% drop in the asset's price could wipe out all your money.
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Complexity
Derivatives are complex instruments that require good knowledge of financial markets. Ignorance about the mechanism can lead to heavy losses.
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Counterparty Risk
The other party may deny their promises, and hence, they pose a risk in OTC derivatives.
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Market Risk
Derivatives are affected by different market factors such as interest rates, volatility, and time decay, which can change their value in unexpected ways.
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Liquidity Risk
Some derivatives might not be very liquid, which makes it hard to buy or sell them without changing the market price.
How to Mitigate Risks
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Learn yourself
Before trading derivatives, invest time in understanding how they work. Read books, take courses, or consult financial advisors.
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Start Small
Start with a small sum just to understand how the market performs and how derivatives really work.
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Use tools to manage risks
Use stop-loss orders and limit orders to control potential losses.
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Diversification
Don't put all your eggs in one basket. Create a diversified portfolio to minimize the risk of losing all your money.
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Stay Updated
Keep yourself abreast with market news, economic signs, and events that may affect your investments.
Is trading derivatives right for you?
Derivatives are powerful tools and can add value to your investment approach if used in the right way. They offer the possibility of obtaining high returns and good risk control. However, they're not for everyone because there's a great deal of risk involved.
Consider your money objectives, your risk tolerance level, and your experience before entering the derivatives trading environment. If you are relatively new to investing or very uncomfortable with high risks, you could prefer using more common investments, such as stocks and bonds.
Being proactive about learning about derivatives, good risk management, and consideration for professional advice can help in making derivatives a beneficial addition to your investment portfolio. Remember, the mantra of good investing is that it is not only about high returns but also about good risk management. Knowing the pros and cons of trading derivatives will make you better at making the right decisions that fit your investment goals.
Happy Investing.