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Derivatives Definition: Types, Benefits and Risks of investing

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Derivatives

What are Derivatives?

Derivatives are financial contracts between two or more parties whose value is derived from the performance of their underlying assets. Here the assets could be stocks, bonds, currencies, commodities, or other securities. Derivatives are used in many different financial markets around the world and are often used to hedge risks and protect against losses. 

How do Derivatives work?

Two or more parties can make a contract to buy or sell their assets at a specific price in the future. It is like one party is predicting the price will fall whereas the other party is predicting the price will rise. They both will strike at a price where the contract will be performed. These derivatives can now be traded on stock exchanges and the OTC platforms. 

One of the main benefits of derivatives is that they help the investors to manage their portfolios and control the amount of risk they are taking on. Derivative gives the investors leverage to speculate on the future price of the underlying assets.

Types of Derivatives:

Derivatives can be classified into four major types based on their working principles.

Forwards

These are the types of derivatives that do not trade in stock exchanges and are not standardized and regulated. Such derivatives are generally traded on OTC (Over-the-Counter) platforms with minimal regulations. Forwards are customized contracts held between two or more parties to buy or sell an asset at a specified price at a specified future date. This means, that either the price of the underlying asset might be increasing or decreasing, the contract will close at that specified price held in the contract. The price that day will be the price the underlying assets are traded between the parties.

As these are not regulated, one of the main risks associated with this type of contract is the counterparty risk. This is a type of risk where the counterparty is not able to make payments as per the contract. Yes, this can be minimized by using collateral deposits but is not mandatory on all platforms. 

Futures

Futures derivatives are similar to Forwards, but they are traded in stock exchange platforms and are standardized and regulated. As these derivatives are regulated, the risk like counterparty risk is not an issue anymore. As like forwards, the contract will let the parties either sell or purchase an asset at a future specified date at a specified strike price. Generally, investors use these derivatives to hedge their risk in the future.

Futures Example

Let us understand this with an example. Suppose Investor A has some assets and he thinks that the price of his asset will fall in the future. So he opens up a contract, in which he will state the specified date he wants to sell those assets and the specified price for those assets. Investor B might find this an opportunity to earn more. B believes that the asset value will increase in the future. Now he will capitalize on this opportunity by joining the contract to purchase those assets at the current specified price. 

By the deadline, the price of that asset might be higher or lower than the specified strike price. If the price is lower than the strike price, investor A will be on the safer side. If the price is higher than the strike price, investor B will profit higher. 

Options

An option is simply a right given to the investor that lets them either purchase or sell underlying assets at a price called strike price. As options are the rights given to the investors, it is not considered an obligation because you can exercise your right or you may just trade it with other investors. Option trading is another great technique used by investors to earn more money or to hedge their losses. 

Options are of two types, Call Option and Put Option. Call options give the investors the right but not the obligation to purchase (buy) shares (underlying stocks) at a specific strike price within the given period of time. They are like warrants for a Special Purpose Acquisition Company (SPAC). Put Option gives you the right to sell a share at a strike price within the given period of time. You can understand it as insurance for your stocks. 

Swaps

As the name says, swaps are the derivatives used to exchange one security for another before a specified future date. Yes, there are multiple factors that are considered before implementing the contract so that one asset isn’t overvalued or under-valued than the other one. These derivatives are generally seen to be used in currency exchanges where they will exchange their currencies before the specified future date even if the price of the currencies might fluctuate till then.

Advantages of Derivatives:

Some of the main advantages of investing in derivatives are:

  1. Derivatives are a good way to protect against market volatility and reduce the risk of losing money in a market crash.
  2. They allow investors to take an early position in a particular market, and then profit from the difference in price between the derivative and the asset. 
  3. Derivatives such as warrants give you leverage and more coverage in the stock market.

Disadvantages of Derivatives:

Some of the main disadvantages of investing in derivatives are:

  1. Derivatives can be risky if they are held for the long term. As they are completely dependent on the underlying asset.
  2. A small change in the underlying asset might change the price of option derivatives drastically. Also during options trading, unpredictable risks like “Gamma Squeeze” might come along.
  3. As derivatives like forwards are only traded on OTC platforms, risks like counterparty risk and limited liquidity might occur. 
  4. Some derivatives like warrants can be redeemed to get the required number of stocks. This will dilute the share outstanding resulting in a drastic fall in stock price.

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