Upon venturing into the financial world, the term "derivatives" does sound confusing. Don't be scared off by that because it is not really as daunting as it seems at first glance. Let's break down what derivatives are, how they work, and why they matter in simple terms.
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:
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:
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.
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.
Anything finance-related has its upside and downside. Here is what you must learn:
Advantages:
Disadvantages:
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.
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.
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