Derivatives are popular because of their flexibility, profits, and potential to offer indicators related to market sentiments [movements]. When financial market experience cyclical volatile phase, derivatives trading is a lucrative option. However, like any other investment decision, it is necessary to understand the market conditions clearly and strategize to take advantage.
What is the meaning of derivatives?
Trade market is a place where people have conflicting views about future stock prices. Some expect prices of an underlying asset to rise in future, but there are the remaining who are skeptical and assume the prices to go down.
Trade market gives traders information and freedom to trade on the basis of gut feelings. With shared knowledge, traders are aware about the market behavior in future. Thus, they take bearish or bullish position with respect to future stock price. This is the formation of a general ‘Derivative Market’.
Financial instrument derivatives derive their price totally from existing asset it represents including currency, commodity, equity, bullion, ROI, livestock, or bullion. The common feature that all these underlying financial instruments experience is the risk of price fluctuations.
How derivatives trade work?
When traders invest in derivatives, they actually bet on the represented assets rising or falling value by a definite percentage within a specific time period. Derivates are just contracts, which gain their value from underlying securities current or future prices.
Derivative trade means you are buying a promise from original asset owner to transfer asset ownership instead of physical asset. This agreement gives traders or investors flexibility and is the most appealing trait.
Difference between derivatives and equity shares
Shares are physical assets you hold but derivatives obtain their value from this shares being held. Common derivatives kinds are options, futures, convertible bonds, and warrants.
Why practice derivatives trading?
Derivatives trading acts as coverage against unpredictable price movement, market fluctuations, uncertainties of business performances and returns
In brief, derivatives allow traders to –
- Trade on price moves
- Earn profits from short-range mispricing
- Carry uncertainties and risks
Derivates are bought and sold by market participants with a purpose.
Derivative market determined players or participants
- Hedgers
- Speculators
- Arbitrageurs
Hedgers
Hedging means decrease in risk. The investor, who looks at ways to reduce his risk, is called ‘Hedger’. In a derivative market, the hedger takes a position, which is opposite to risk he is exposed to.
For example, an investor assumes that the Colgate share price will get affected due to the upcoming policy announcement. He invests in derivatives to offset some risk to his portfolio. Hedging is an insurance against defaults in case of the underlying asset price moving unfavorably.
Speculators
Speculators theorize expected price movements, before taking accordant position to gain more profits. Speculators are very high-risk takers, who participate in derivative markets just with an aim to earn profit.
They depend on prompt moving trends for predicting possible market moves, which can range from fluctuating ROI to consumer taste changes to economic development indicators corresponding with market timing and more. Speculators either make maximum profit or equally huge losses. These are high net investors aiming to diversify their portfolio and maximize profit in a short time.
For example, if speculator assumes a specific company stock price will fall in a couple of days due to some forthcoming market development, he will short sell these in derivative market. If his assumption is right then he would earn good profit but in case of bad call, he will suffer equal loss. Learn more about speculation on www.capital.com.
Arbitrageurs
Arbitrageurs can be regarded as opportunists because they enjoy creating an extremely fast paced market conditions with rapid decisions. Sometimes stock price in cash market is high or low than expected in comparison to derivative market price.
Arbitrageurs take advantage of these inefficiencies and imperfections. In addition, they are responsible in increasing market liquidity or make market more fluid.
How derivative market participants are significant?
Derivative markets and important players [traders] help to redistribute the risk, which is produced by domestic and global economies. Prices get regulated and assets get protected from getting excessively undervalued or overvalued. Equity market functions smoothly and efficiently because of derivative market participants.
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