Investing in derivatives is often considered to be complicated. However, this type of trading provides you with the option to buy or sell any security. When you trade in a derivative, you do not own the underlying asset. But you predict its price movement and get into an agreement with the other party.
Derivatives are classified into several types. Some of these include swaps, futures, forwards, and options. Furthermore, there are many risks associated with derivatives trading but these provide an alternative to invest in the market.
Common terms related to derivatives are as follows:
- Counterparty
Several derivative trades include counterparty. This is the person who is responsible for the other part of your trade.
- Underlying Asset
This is the security that is being traded and is the basis for determining the term structure, price, and risk. The potential risk of the underlying asset is the primary aspect that determines the riskiness of your derivative trade.
- Pricing
The price of a derivative is complicated. A strike price is a price at which you exercise the instrument. Fixed income derivatives may have a call price. It is the rate at which the issuer is able to convert the security.
- Position
You may either assume a long or a short position. When you assume a long position, you buy the derivative. A short position implies that you are the seller of the instrument.
Types of derivatives
Derivatives are classified as options and futures, and swaps.
- Options
Such contract gives you an option to exercise your rights without any mandatory obligation. You may assume long call or put and short call or put.
- Futures
These are contractual agreements where you agree with the counterparty to buy or sell the underlying asset at a pre-determined strike price. These are often at the spot price and the difference between the spot price on the contract date and the future price is your profit or loss on the trade.
- Swaps
Such trades often arise when one party has an advantage over the other party. For example, you may be able to borrow funds at a variable interest rate while the counterparty may be eligible for a fixed rate. Some of the common types include currency, interest rate, and commodity swaps.
Using derivatives in your investment portfolio
You may trade in the derivatives market for three reasons. These include hedging, higher leverage, and speculating the price movement of the underlying asset.
- Hedging
This is used as protection against the risk of the assets. For example, you may choose a put option to protect yourself against negative price movement of a share you hold. In this situation, if the price increases, you earn capital benefits. However, if the price decreases, the put option protects you from the potential loss.
- Leverage
Options are beneficial in volatile markets. A favourable price movement of the underlying asset magnifies the option movement.
- Speculation
This is a technique where you bet on the price of the underlying asset in the future. Options provide you with the ability to leverage your position; you may execute large speculative plays at competitive costs.
Financial derivatives may be bought over-the-counter (OTC) or through the market. OTC contracts are private between two parties and are not regulated. Standard contracts are traded on the regulated markets and are less risky because of the presence of an intermediary.