Those who have studied science and still remember some of it know that Newton’s third law of motion can be derived from the second law of motion. Therefore, these laws of motion are not independent as we may think.
Likewise, even in the stock market, many things are not independent as we think. They derive their values from somewhere else. A derivate is a financial contract that derives or associates its value with something else. This is what we are going to learn in this article.
- What is a Derivative?
- What is Derivative Trading?
- Types of Derivatives
- Advantages of Derivatives
- Disadvantages of Derivatives
- Quick Summary
What is a derivative?
First and foremost, in financial terms, a derivative is a financial contract. Derivatives, or as they are also called financial derivatives, derive their value from some other asset. Such assets from whom a derivative derives its value are known as underlying assets or simply underlying. As the price of the underlying asset changes, the price of the derivative fluctuates.
A derivate contract is set between two or more parties and is traded on an exchange or over-the-counter. Some of the common types of financial derivatives are futures contracts, forwards, options, and swaps.
Traders use derivatives to explore different markets and trade different assets. The most common underlying assets for derivatives are stocks, commodities, currencies, and market indexes.
What is Derivative Trading?
Derivative trading is just the regular buying and selling of securities. It involves buying and selling financial contracts in the stock market. However, in derivative trading, instead of paying the whole amount up front, traders pay only an initial margin to the stock brokers. In derivative trading, the buyers and sellers are on the opposite sides of the bet. Both of them bet on the future price of the underlying security. One is hopeful that the price of the underlying asset to rise, while the other is speculating it to come down.
Types of Derivatives
There are several types of financial derivatives available in the market. Each of these derivatives serves specific purposes and comes in very handy for experienced traders. Once a trader has a hang of the types of financial derivatives, they can make a good profit in the stock market.
Let’s look at some of the examples of types of derivatives.
A futures contract is a legally binding agreement between two parties to buy or sell an underlying asset at a set price on a future date, which is also called the expiry date. A futures contract is executed directly through a regulated stock exchange. Futures derivatives are generally used to speculate in the commodity and equity markets.
Forward contracts are similar to futures contracts. However, forwards are not traded through a regulated stock market; hence they are traded over-the-counter. This type of derivative is used for hedging. As they are over-the-counter (OTC) contracts, they do carry more risk for both parties involved. Forwards have counterparty risk. It is a kind of credit risk where the buyer or seller may not be able to keep their part of the obligation. Therefore, if the buyer or seller becomes insolvent, the other party may not have a way to save their position.
Options are contracts that give the buyer the right to sell or buy an asset at a certain price on the expiration date of the contract or before that. The crucial thing here is that the buyer is under no obligation to trade the security. If the buyer does trade, then it is called exercising the option.
In simple terms, ‘swap’ means to give something for something else or to make an exchange. When two parties agree to exchange their liabilities or cash flows from separate underlying assets held by them in order to hedge their risks, then it is known as a swap contract.
Advantages of Derivatives
Derivatives are used for making the most out of a situation that a trader is predicting. Let’s see the advantages or uses of derivatives in the stock market.
Low transaction costs: The transaction cost while trading in derivatives is lower compared to securities like debentures or shares because derivative contracts work as risk management tools.
Used in risk management: The biggest use of derivatives is to hedge risk. The value of a derivative contract is directly linked to the price of its underlying asset. Hence, they are used to hedge risks associated with changing price levels of the underlying asset.
For example, a trader buys a derivative contract, and its value moves in the opposite direction to the price of the asset they possess. Now, the trader will be able to use the profits in the derivatives to offset losses in the underlying asset.
Determining the price: Derivatives are often used to determine the price of an underlying asset.
Disadvantages of Derivatives Trading
Involves high risk: Derivatives trading is very volatile simply because the value of underlying assets fluctuates rapidly. Therefore, traders can incur heavy losses.
Counterparty risk: Some derivative trading, like forwards, are not regulated and carry the counterparty risk.
Speculative: Derivative trading is based on speculation. Traders bet on how the security will move in the future. While their speculations are based on information and experience, they can go wrong due to reasons that are unforeseen.
We hope you might have understood everything about what is derivative in stock market. This should help you to increase your investment horizons and move towards the deep ends.
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- Derivatives are financial contracts that derive their value from their underlying assets.
- Derivative instruments must only be used when the trader has in-depth knowledge of the exchange and can make educated guesses on how the market will behave.
- There are several types of derivatives in the stock market: Swap, forwards, futures, options, etc.
- Each type of derivate serves its purpose. Thorough knowledge is a must before using them.
- Advantages of derivatives include hedging of risk, low transaction cost, etc.
- Disadvantages of derivatives include high risk and counterparty risk, among others.