Financial markets are tools that give people the opportunity to procure and sell various commodities as well as other financial mediums. This involves investors selling, buying, and trading these financial instruments in the stock market within the basis of a fair market pricing. One of the widely-utilized instrument is the derivative.
What is a Derivative?
As its name implies, a derivative is a form of a financial instrument from another form of an underlying instrument and consequently traded as a commodity. Derivatives are typically used for products like gasoline, gold, oil, and even currencies.
The value of stocks may fluctuate, exchange rates may change, and commodity prices may decrease or increase. These are the situations where derivatives can be of help. Derivatives can help you acquire more profits by correctly making a guess about the future price or develop a safety net from all the losses in the market.
What are the Uses of Derivatives?
Financial markets often pose various risks within activities, and the change of losing assets are high. In this case, here are some of the reasons why derivatives may be a handy tool:
- Earn money on idle shares. Long term shares are difficult to trade or sell. However, you want to make the most of the fluctuations happening during the short-term course. Derivatives will allow you to make various transactions without selling your shares. This activity is also known as physical settlement.
- Earn profits from arbitrage. Arbitrage trading involves buying commodities at a low price from one market and selling at a higher price to another market. This way, you are taking advantage of the price difference on numerous markets.
- Protect your commodities from fluctuations. Derivatives allow you to speculate or hedge your securities against the risks of fluctuations. Furthermore, they also protect the securities you are planning to buy from the further increase in price.
- Transfer risks. Considered as the most important function of derivatives, the purpose of transfer of risk is to improve safety of securities. People transfer risks to “risk-loving investors” as they trade these securities to improve their profits.
Types of Derivatives
- Futures and Forwards– futures are agreements to buy or sell an asset on a specified time for a specific amount. On the other hand, forwards are unstandardized types of futures, which are not utilized on a stock exchange.
- Options– they are similar with forwards and futures. However, when buying an option, you do not need to hold onto the terms of agreement.
- Swaps– these are agreements to exchange a specific asset for a similar type. This is helpful in reducing the risks of loss for both traders.
Buying and Selling Derivatives
People can buy, sell, or trade derivatives on numerous exchanges. Exchange is also possible through the traditional open outcry, wherein traders will either voice out their prices, making use of electronic systems or hand signals. On the other hand, over-the-counter option poses less transparency and higher risks. Over 95 percent of derivatives are done through OTC, intermediated by a bank.
These are just some of the basic information involved in the financial market of derivatives. There are numerous techniques and strategies you need to develop in order to learn your way around the industry.