If you have recently entered trading and share business, then you must have heard of derivative market. And if you are wondering what does derivative market mean?Why should you enter in it or how to enter in it?Then here is your complete guideabout derivative market. To explain it in simplest term, derivatives are financial contracts whose value changes based on the underlying asset or group of assets. These assets could be anything like stocks, currencies, bonds, commodities or market indices. The value of these assets keeps flickering depending on market conditions. The basic theory of making profit in derivative market is to speculate the future values of underlying assets and invest accordingly. Imagine the equity share you invested in goes through a downfall pertaining to fall on stock value and you suffer loss. In this case, the best option is to enter a derivative market to either speculate the right value and make profit or by shieldingyourself against larger losses.
What are the various types of derivative contracts to invest?
There are four major types of derivative contracts which are as follows:
- Options – Derivative contracts that give the buyer a right to sell or buy the underlying asset at a certain price for a certain time period are option derivative contracts. There is no obligation to practice the option. Here the option seller is also called option writer and the specific price is called strike price. American options come with a liberty to exercise at any time before expiry date. Whereas European options can only be exercised on the date of expiry.
- Futures – The standardised contracts that enable you to buy or sell your asset at the price agreed upon earlier at a specific date are future derivative contracts. The parties involved in future contract are obligated to perform the contract. These contracts are traded on stock exchange and the values are traded market to market each day. Which means that the contract value differs depending on the volatile market conditions.
- Forwards – Just like future contracts, forward contracts are obligated to perform the contract. Although, forwards are neither standardized nor can be traded on stock exchange. The contracts are available over the counter and are not at the market. You can make changes in it as per your requirements.
- Swaps – Swaps are derivative contracts where financial obligations are exchanged between two parties. The cash flows in swap contracts are based on speculative principal amount that is agreed between the two parties without exchange of principal. Interest rate swaps is the most commonly used type of derivative contract.
Why should you enter derivative markets?
There are more advantages to investing in derivative markets other than gaining profits. Here are a few of them:
- Arbitrage trading advantage – Arbitrage trading means buying a commodity or security from one market and selling another. This gives you chance to take benefit of different prices in different markets by trading in them simultaneously.
- Protection against fluctuating market conditions – The volatility of products affects your probability of bearing a loss. To dodge losses, you must look for products in the derivative market that will help you to shell against a falling price of stocks that you own.
- Parking for surplus funds – A few investors also use derivatives for transferring risks. Although, a lot of people use it for making profits and speculations.
You need to deposit a margin amount before starting trading in derivative market. This margin amount cannot me withdrawn until the trade is settled. It is very important to understand the functioning of derivative markets before trading.