Who Should Invest in Derivatives?

Last Updated: 19 Jul 2023

The stock market has proven to be the preferred investment avenue for many investors, beginner or experienced. Furthermore, a growing economy boosts corporate earnings, and eventually, increases an individual’s average income. For investors, it brings good news as there is more money to invest and multiply wealth. Among numerous asset classes that offer profitable opportunities, seasoned investors look to invest in Derivatives. As it allows portfolio diversification and hedging against the prices of various other asset classes, it makes up for an ideal investment.

What are Financial 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. Derivatives are usually in the form of a contract, where the buyer is under an obligation to buy or the seller is under an obligation to sell the underlying asset at a specified price on a certain date in the future. Derivatives can be used to hedge a position, speculate on the directional movement of an underlying asset, or give leverage to holdings.

How do Financial Derivatives Work?

Fluctuations in underlying assets such as stocks, commodities, exchange rates, currencies, etc. determine the prices of a financial derivative contract. Futures contracts, forwards, options, and swaps are examples of common types of derivatives. They are influenced by changes in the amount of time to expiration, interest rates, and the cost of holding the underlying asset. Derivatives are also sensitive to demand and supply factors.

There are two major ways through which an investor can trade in derivatives:

• Futures Contract: It is a standardized 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. This contract remains legal until the time of expiry of the contract.
• Options Contract: This kind of contract is generally permitted in top commodities wherein the trader has the right but not a legal obligation to buy/sell the underlying asset at a predetermined price. Such a contract helps investors to make a profit based on price fluctuations without buying/selling the underlying asset mentioned in the contract.

Who are the Participants in the Derivatives’ Market?

The participants who invest in derivatives are classified into the following two categories:

• Hedgers: They are the producers, manufacturers, etc., of the underlying asset and generally enter into a derivative contract to mitigate their risk exposure. Simply put, hedgers ensure that they will get a predetermined price for their assets and would not incur a loss if the prices go down in the future.
• Speculators: These individuals are actual traders who try to predict the future price of commodities based on various factors and monitor their prices regularly. If these speculators think that the price of a particular asset will go up, they buy a derivatives contract of that asset and sell it at the time of expiry to make a profit.

Conclusion

While there are several drawbacks, such as counterparty risk and the inherent risks of leverage, derivatives can make it easy to achieve financial goals. A thorough analysis of the market is a prerequisite in the process of making derivative trading successful. Gradually, you will become aware of your investment goals, ability, and capacity to take risks, as experience is the best teacher in the financial market.

Frequently Asked Questions

Why invest in Derivatives?

• There is great potential to multiply your wealth.
• If you are a manufacturer, you can hedge against the risk of losses.
• If you are a speculator, you can make profits by investing in the derivatives market based on the price fluctuations of the underlying asset.

What are the Benefits of Trading in Derivatives?

Trading in derivatives can allow you the following benefits:

• Mitigation of portfolio losses against other asset classes.
• Effective portfolio diversification.
• Hedge against market volatility.
• Increase the chances of overall portfolio profits.