Derivative trading is a financial security that has a value depending on the underlying asset as the benchmark. It is a contract itself shared between two parties as it derives its price from the market fluctuations of the underlying asset. Assets used in trading derivatives include currencies, stocks, market indexes, bonds, commodities, and interest rates. All of these assets can be bought from brokerages.
Understanding Derivative Trading
Exchanges or Over-the-counter trading is possible with derivatives. In fact, a good number of derivatives are traded over-the-counter and have the possibility of encountering counterparty risks. This type of risk offers danger if one of the parties involved defaults. And because it is unregulated, both parties are exposed to this risk. Exchange-traded derivatives, on the other hand, are more standardized and strictly regulated.
Forms of Derivatives
Different types of derivatives are available in the market and can be used for risk management, speculation, and even when leveraging a position. It is a fast-growing marketplace offering a multitude of products that fits your needs and risk tolerance.
Futures
Futures contracts also known as futures are a set of agreements between the broker and the seller for the delivery and purchase of an asset at a designated date in the future.
Forwards
Forward contracts also known as forwards are just like futures. The thing about it is that it cannot be traded through an exchange, but only for over-the-counter transactions. During the drafting of the contract, the buyer and the seller can create customized terms, settlement prices, and sizes for the derivative. Since it is only done through over-the-counter transactions, the counterparty risks are doubled.
Swaps
It is another derivative that is commonly traded through a cash flow. For instance, the trader can utilize an interest rate swap when switching from one variable interest rate loan to another fixed interest rate loan.
Options
Similar to futures that have agreements shared between parties in order to buy and sell a specific asset with a predetermined date in the future over a specific price. The major difference between options and futures is that buyers aren’t obligated to pursue the buy or sell agreement. It is basically an opportunity and not an obligation, unlike in futures wherein the agreement is strictly enforced.
Advantages of Derivatives
It is known that derivatives offer a great advantage among investors and even businesses. They can lock prices, and mitigate risks to limit the costs. Additionally, derivatives are bought on margin, which is a borrowed fund, making them affordable among retail traders and investors.
Disadvantages of Derivatives
If there are advantages, it is also important to note the disadvantages. From here, you will know if derivative trading perfectly fits you. The disadvantage of a derivative is that they are difficult to value since the price is based on the other asset. There are also uncontrollable risks of derivatives such as counterparty risks that are hard to predict and value. Derivatives can also change randomly during the expiration time. You will also have to shoulder the cost and interest of holding the asset.
