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Derivatives! Know before you trade

, October 28, 2013, 0 Comments

 

Derivatives! Know before you trade

The stock market particularly derivatives trading can prove to somewhat of an uphill task for people to understand. Understanding the nitty-gritty of investing in the same can be an even more complex task.


In the current economic climate of extreme volatility, it can be a dance with the devil himself! What we need is a financial instrument that allows us to hedge risk, decide an optimum time frame and price. This is where derivatives come in to the picture.

As a class of instruments, Derivatives have held the interest of investors over the years. They are popular given their flexibility, returns and their potential to provide market watchers with indicators of market sentiments and mindsets.

Definition:
A security whose price is dependent upon or derived from one or more underlying assets is called a derivative. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset.

The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Derivatives are different from stocks given as while stocks are assets themselves, while Derivatives derive their values from other assets such as stocks, currencies, bullion, commodities, livestock etc.

Derivatives Trading:
Derivative is an instrument, such as Futures and Options contracts, which derives their values from an underlying security, or an index. With derivatives, what happens is that you enter into an agreement with the original asset owner to transfer ownership rather than the asset itself.

This allows for greater flexibility and appeals to many investors. This is a legally bonding between two or more parties, where the reason for the contract, time period and the amount is specified. The minimum value of a contract is 2 lakhs. No contract value would be less than 2 lakhs.

Classification:
Derivatives are basically classified into Futures and Options.

Future is a contract to buy or sell specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.

An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. ‘Option’ as word says, the buyer has the right to decide whether he will conclude the deal at a future date or not.

While a Futures Contract is a legally binding agreement to buy or sell the underlying security at a future date an Options Contract is relatively more flexible wherein you can choose to either honour or abandon the Contract should there be other developments and charges a premium for the availability of choice.

The Risk Factor:
There is a large amount of risk involved as the derivatives market deals in speculation. In fact, Warren Buffett once called derivatives ‘financial weapons of mass destruction.’ However, there is a stringent framework of control in the exchanges which deal in derivatives.

Many major companies employ derivatives to hedge their risk. This is a good step to take if you’re a cautious investor with limited funds. However, if you’re a risk taker with ample funds and possess innate understanding of market trends, play the markets to your advantage.

To derive maximum profits though, you need to understand this complex world embedded with the market. It’s not too difficult, happy investing!

To learn more about derivatives visit our page.


ABOUT THE AUTHOR OF THIS POST
KOTAK SECURITIES
Kotak Securities is one of India’s largest share broking firm offering share trading account, online trading, option trading, mutual fund and currency trading services along with a research division specializing in Sectoral Research and Company Specific Equity Research. We also provide you with latest updates and news from share bazaar. click here to visit kotak securities website.


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Source: Option Chain Chart : NSE