Basic Guide to Derivative Markets and Derivative Trading

Basic Guide to Derivative Markets and Derivative Trading

Derivative trading has been happening in some form or another since centuries. Yet it’s the 1970s when derivatives gained widespread popularity. Derivative trading is when you trade in the derivative, which is a financial instrument, whose value is determined by an underlying asset. Here is a basic guide about the derivative market and derivative trading.

What is a Derivative Market?

The derivative market is where derivative trading takes place. In the derivative market, two types of trading take place. In the first type, the derivatives can be exchange-traded. In the second type, they are traded over the counter or OTC.

Derivatives which are traded on the exchange are highly regulated. OTC derivative trading is unregulated and has more counterparty risks. You can trade in derivatives through futures trading and options trading.

What are the uses of Derivatives?

Helps You Hedge Your Securities

A derivative trader can hedge his/her securities from the price fluctuations in derivative trading. If an investor has possession of some shares, then those could be protected from any downfall by entering in a derivative contract.

Option to Transfer Risks

In derivative trading, an investor can transfer the risk to a risk-seeking investor. The risk-seeking investors can then enter into trades with high risks in hope to earn some profits.

Arbitrage Benefits

You can take advantage of price fluctuations in the two markets. Arbitrage is simply buying in one market at a low price and selling in another market at a higher price.

Derivative Market Participants

Hedgers

Hedgers are a type of traders who aim at protecting themselves from price fluctuations. These hedgers undertake an exact opposite trade in the derivatives market. Hedgers pass on the risk to investors who are willing enough to take it.

Speculators

Speculators are the definition of risk-seekers. Speculators are traders who take high risks so as to earn huge and quick gains. Spectators try to take maximum advantage of the price fluctuations. Speculators provide liquidity in the derivative market.

Arbitrageurs

Arbitrageurs are the ones who take advantage of trading in two markets. If there are the same securities being traded in two different markets then arbitrageurs might buy it in one market and sell in the derivatives market and vice versa.

What are the Types of Derivative Contracts?

Derivative contracts are of 3 types:

  1. Forward contracts are contracts where two parties come to an agreement of trading an asset fora pre-decided price at a particular date in the future. These contracts are private and traded over the counter.
  2. Future contracts are similar to forward contracts where two parties come to an agreement of trading an asset at a pre-decided price and date in future. These contracts are traded on the exchange.
  3. Options contract give the buyer a right to buy an asset but not an obligation to do the trade in the future.

How can you trade in Derivatives?

  • Before you decided to enter the derivative market, make sure you understand the market properly.
  • Check if you have the proper finances for doing derivative trading, as it involves you to maintain a set margin amount which you cannot withdraw until the trade is done.
  • Decide on the stock you want to trade after thorough analysis.
  • Do the transaction through a trading account.

When you do derivative trading make sure that you book your profits or losses.

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