A derivative is a deal between two or more parties where the value of the contract is derived from the value of the underlying asset. If derivatives and its different forms sound quite complicated for the unacquainted, it’s because it is.
A futures contract is a derivative instrument since its value is affected by the way in which the underlying asset behaves. In the same manner, stock options are derivatives in that their value is derived from the performance of the underlying stocks.
The basis of profits that you can earn from them is from the changing prices within the underlying asset, security, or index.
Traders can profit from any anticipated fall in the index price. And they can do that through the sale of the appropriate futures contract. This what you call going short, and there is a lot of speculation involved in this process.
Derivatives can be used as a hedge to use risks linked with the price of the underlying asset to be exchanged between parties involved in the contract. The prices will still be changing, even if the amount of risk is already reduced by hedging.
Derivatives enable investors and traders to have instruments that can let them buy or sell option to a security. In other words, derivatives are the type of instruments that let investors bet on the anticipated direction of the price movement of the underlying assets, which is not really owned by the investor.
As you may already know, there are many different kinds of derivative instruments, including options, swaps, and futures.
The usefulness of leverage can be really improved by using derivatives. These options are most valuable when the market is extremely volatile. The movement of the option is magnified if the price of an underlying asset moves strongly in the desired direction.
Through this method, investors bet on the future price of the asset. As options provide investors the opportunity to leverage their position, large speculative maneuvers can be done at a lower cost.
You can buy and sell derivative in two main ways. You can either trade them over the counter or on an exchange.
OTC derivatives are contracts that are made between parties on a private basis. An example of this is swap derivatives. The OTC market is larger than the exchange market, and it is relatively less regulated.
On the other hand, derivatives traded on an exchange are standardized contracts. The biggest difference you can spot between these two is that OTC contracts are created privately. That means they are not under any strict regulation found on an exchange. The derivatives risk is missing from exchange derivatives, where the clearing house – the exchange – serves as a go-between.
In other words, when you are trading derivatives on an exchange, you are basically entering an agreement with the exchange and the other party. However, your main obligations will lie in the terms set out by the exchange on which you are trading the derivative.