Derivatives sound complicated, but let's be honest: they are actually a super fun financial tool that can help you handle risk, gain profit, and even diversify your investment portfolio. If you ever think about what derivatives are and how they work, here is the beginner's guide for you.
What Are Derivatives?
In simple words, derivatives are financial contracts whose value is driven from an underlying asset. It could be anything-stocks, commodities, currencies, interest rates, or even market indices. Derivatives are agreements between two parties to buy or sell the asset at some specific price on a future date.
Derivatives in India are regulated by SEBI, the Securities and Exchange Board of India. Most derivatives trade on exchanges like NSE and BSE as the most prominent exchanges in India for equities.
Why Should You Know About Derivatives?
Derivatives are the most extensively used tools by investors, traders, and companies in pursuit of the following:
Hedge Risk
Suppose you are an exporter anxious about fluctuating currencies. You can use currency derivatives to hedge an exchange rate, thereby hedging your risk.Speculation
Traders use derivatives to bet on the price changes of an underlying asset and make a profit.Leverage
You can control a large value of an asset with a small investment in derivatives, thereby multiplying possible returns, as well as the risks.
Common Types of Derivatives
There are four main types of derivatives you will encounter. Here they are:
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Futures
A standardised contract to buy or sell an asset at a given price on a future date. For example, Nifty Futures let you speculate on the movement of the Nifty index.
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Options
A contract that gives you the right but not the obligation to buy or sell an asset at a specific price. There are two types of options: Call Options: Allow you to buy an asset. Put Options: Allow you to sell an asset.
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Swaps
Agreements to exchange cash flows or interest rates between two parties. Swaps are mostly used by businesses and institutions.
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Forwards
Similar to futures but not traded on an exchange. These are private contracts and customizable.
How Do Derivatives Work?
For instance, in case basis you recent research on markets that Nifty 50 is going to go up in the next month, then you can purchase a Nifty Futures or a Nifty Call Option. If indeed the index goes up, you will make money through the price difference.
But are Derivatives really for you?
Derivatives are not for everyone. They are best suited for the experienced investor, trader, or business looking to hedge risk or speculate. For the beginner, consider consulting with a financial advisor or learn about derivatives before you start investing in it. There are these things that you should keep in mind:
- Risk: Derivatives may be powerful but carry huge risks. They can multiply your losses as easily as they multiply your profit.
- Learn the Basics: Before diving in, familiarize yourself with how derivatives work and practice with small amounts.
- Stay Updated: Market conditions and policies influence derivative prices. Regularly follow financial news and trends.
Derivatives can add value to your investment strategy if used wisely. Invest small, stay knowledgeable, and always learn.
Good luck!