DERIVATIVE

Derivative Trading

A derivative is a contract or product that derives its value from an underlying asset. Derivatives can include a wide range of such assets including indices, currencies, exchange rates, commodities, stocks or the rate of interest. The buyer and seller of such contracts have opposite estimations of the future trading price. Both the parties bet on the future value of the underlying assets to make a profit.

Derivative trading is similar to a regular buy and sell process. But instead of paying the whole amount up front, a trader pays only an initial margin to a stockbroker.

Different Types of Derivatives

Depending upon the conditions of a contract, derivatives can be of the following types –

Futures – A futures contract is a legal agreement between two parties to buy or sell the underlying asset at a predetermined future date and price. The contract is executed directly through a regulated and organised exchange.
Forwards – Forward contracts are similar to futures except the deal is not made through an organised or regulated exchange. Since these are Over-The-Counter (OTC) contracts, they carry more counterparty risk for both parties involved.
Options – An options contract gives a trader the right but not an obligation to buy or sell an underlying asset at a predetermined future date and price.
Swaps – A swap is a contractual agreement between two parties to exchange cash flows at a future date based on a pre-planned formula. Similar to forwards, they are OTC contracts and consequently not traded on exchanges.

Participants in a Derivatives Market

There are four participants involved in derivative trading. They are as follows

Margin Traders

Arbitrageurs

Traders and Speculators

Hedgers

Advantages of Derivative Trading

Low transaction costs
Used in risk management
Market efficiency
Determines the price of an underlying asset
Risk is transferable

Disadvantages of Derivative Trading

After knowing what is derivative trading, it’s imperative to be familiarised with its disadvantages as well.

Involves high risk
Counterparty risk
Speculative in nature

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