What are the different types of Derivatives?

However, if you like having control over the placement of your funds and would like to make your investment decisions yourself, it is best to study the market in detail and be aware of its affecting factors. Studying the market for a while and understanding the factors that affect its ups and downs is extremely helpful if you choose to begin investing in derivatives and their types. Derivative trading can prove to be an excellent way for experienced investors to generate guaranteed returns on their invested amount.

What Are Derivatives?

Derivatives are financial contracts that derive their value from an underlying asset such as stocks, commodities, currencies etc., and are set between two or more parties. A derivative contract is between two or more parties, where the value of the derivative is derived mainly from fluctuations that occur in the price or value of the underlying assets. Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or leverage holdings.

While there are different types of derivatives, each enables investors to invest their funds in several ways that guarantee the protection of their initial investment and generate additional profits. It is the best tool for investors who wish to predict their cash flows for the future and hedge against the losses of other asset classes.

Types of Derivatives:

 

There are four types of financial derivatives that are listed below:

1. Options

An option contract is a contract wherein the buyer attains the right to trade the underlying asset over a predetermined period. The price that both parties determine is known as the strike price, and the seller of the option is called the option writer. The buyers, however, are not obliged to exercise the option for trading in the underlying assets. If they don’t want to exercise the options contract, they can just pass on the exercise right after paying the premium to the option’s writer.

2. Futures

Futures contract is a standardised legal agreement between the buyer and the seller of the underlying asset. Under a futures contract, a predetermined quantity and price are agreed upon, payable at a specific future date. Unlike Options, the parties in a futures contract are legally bound to exercise the contract. This contract remains legal until the time of expiry of the contract. While derivatives and their types can be traded either over-the-counter or through an exchange, futures are standardised and are always traded via the exchange, making them credit-risk free.

3. Forwards

Forward contracts are similar to futures as they also come with an obligation to execute the contract. However, unlike futures, forwards are traded over-the-counter instead of through an exchange. Forwards also offer the contracting parties the option to customise the contract as per their requirements.

4. Swaps

Swap derivatives comes under the over-the-counter contracts (OTC). It enables parties to swap their financial obligations or liabilities, among which interest rate swaps are the most common. The cash flows within this contract are based on a rate of interest, and while one cash flow is generally fixed, the other is susceptible to change as per a benchmark interest rate.

How To Trade In The Derivatives Market

The most important thing to understand before you begin investing in different financial derivatives is the market itself. It is wise to thoroughly educate yourself regarding the current market conditions and the factors likely to impact them.

Each financial market is dependent upon factors that include economic, political and social factors. Any of these affecting factors is enough to cause a significant shift in the market. Hence, you must be aware of these developments and prepare for them in advance.

Here is how you can trade in derivatives effectively:

  • You need to create an online trading account before you can begin trading in different types of derivatives. However, if you are using the services of a broker for trading in derivatives, you can place your orders over the phone or even online.
  • When you start trading in derivatives and their types, you are required to pay a margin amount, which you cannot withdraw until the contract is executed and the trade has been settled. If, while trading, your margin amount falls below the minimum acceptable amount, you will get a margin call to rebalance it.
  • Make sure to thoroughly understand everything about the underlying asset. Keep your budget in mind and ensure that it is adequate for meeting the financial requirements of the margin for trading, cash in hand, and covering the prices of the contracts.
  • While you are investing, you should remain invested in the contract until the trade has been settled.

Conclusion

Derivatives are a great financial instrument for experienced investors who want to diversify and invest their surplus funds into generating good profits. Furthermore, derivative contracts are also an ideal investment method for hedgers who are extremely risk-averse. However, as derivative trading can be complex, it is wise to gain market knowledge and learn about the obligations that come with derivative trading.