Understanding Derivatives: A Simple Guide By AlmondzTrade for Everyday Investors

What Are Derivatives?

Basically, a derivative is a financial contract whose value depends on the assets kept against it, such as stocks, bonds, or even currencies. Consider the case of making a bet on a cricket match's outcome. How good your bet is depends on how the teams perform—that is your "underlying asset." In finance, a derivative works exactly like this: its value depends upon how well its underlying asset performs.

Here are a few common kinds of derivatives you might run across:

• Futures: These are contracts in which you promise to buy or sell the underlying assets at a particular price on some date in the future. 

• Options: These give you the right—though not the obligation—to sell or buy at a particular price before a particular date.

• Swaps: If we talk about how swaps work, we can understand that in the contract, two parties agree to exchange financial obligations. Interest rates and currencies are two examples. 

• Forwards: The same as futures, but these are private agreements between two parties not traded on a public exchange.

Why Should You Use Derivatives?

Why one might desire to use a derivative instrument would depend on what one is trying to achieve. Here's why some investors use them:

1. Protecting Against Risk (Hedging)

Hedging can also be viewed as protecting one from a potential loss. Imagine owning some shares in a company but with the view that the stock is going to fall. You can acquire a put option, which gives you the right to sell shares at an agreed price, irrespective of the market falling in price. In such a scenario, you have hedged.

2. Speculation: A Gamble on Market Moves

Some investors are very keen to use derivatives as a means of making bets on the future price action of underlying instruments. Say, for instance, that you think a given equity is going to rise in value. In this case, you should buy a call option. When the price of the stock goes higher, the value of your option increases, and now you are in a position to profit. But it's a very risky thing to do because if it moves oppositely from what you had anticipated, you could end up losing money.

3. Searching for Price Discrepancies (Arbitrage)

Arbitrage exists if you can profit from price discrepancies in various markets. As an example, let's say a particular stock sells for a different price on two various exchanges. You would sell on the expensive exchange and buy on the cheap exchange to make a profit. In essence, you could use derivatives to fix prices in advance and do this with some help.

What Are the Advantages and Disadvantages of Derivatives?

Anything finance-related has its upside and downside. Here is what you must learn:

Advantages:

• Risk Management: Derivatives may be used to hedge against loss, in which case, they become a potent tool for risk management.

• Leverage: With the derivative, you can control a large position by paying just a small amount of money, thereby amplifying potential profits.

• Flexibility: Derivatives offer you plenty of options, no pun intended, about how you can use your money. You can bet prices will go up or down or even that they will remain the same.

Disadvantages:

• Complexity: The derivatives are cumbersome when it comes to understanding. You have to understand all the nooks and crannies of an underlying asset and how the market functions.

• Leverage Risk: There is a potential that one can lose all their investment. When the market goes against your side, it can cost you more loss than your initial investment.

• Counterparty Risk: This happens when the other party with whom you have the contract fails to deliver its end of the bargain, more so with OTC-traded derivatives.

A Simple Example: Using Derivatives to Protect Yourself

Say you are a farmer growing wheat. You are concerned that the price of wheat may fall by the time you harvest. You can hedge the risk of a wheat price drop by entering into a futures contract to sell your wheat at a price set in the contract in the future. Irrespective of any changes in the market price, you can rest assured about getting the price at which you are going to sell this amount as mentioned in this contract. You have used a derivative to hedge your risk in this example.

Wrapping It Up

The mere mention of the word 'derivatives' makes one think that it is something really complex. At the heart, they are financial instruments that will help you control risk, speculate on the movement of the market or even profit from price differences. While offering great advantages, they also have their dangers, so it's necessary to know how they work before diving in.

Whether you're looking to protect your investments, make some calculated bets, or find opportunities in different markets, derivatives can add a lot of options to your investment strategy. Just remember that you should know what you're getting into and exercise caution.

For more information regarding derivatives and other essential trading tips, connect with us at AlmondzTrade, and our expert team will be happy to assist you in reaching your financial goals.