1. What are Derivatives?
You must have heard of derivatives in financial markets and there are high chances that at some point you must have definitely thought of investing in them. Derivatives are financial contracts which derive their value from an underlying asset. These assets can be stocks, commodities, bonds or even commodities.
Derivatives have been a very lucrative option for investors. There are various reasons which make derivatives a preferred choice for investors. The most significant reason being that derivatives are often used for serving the purpose of risk management. These contracts are an effective measure to hedge risks. The risks can vary from price fluctuations to financial liabilities and more. These risks are often accepted by financially strong traders to extract profits from the market.
Derivatives can prove out to be very helpful for hedging risks. Derivatives are a high-risk high profit instrument are usually volatile in nature. However, before stepping in the world of derivatives, it is important to understand the advantages and disadvantages of derivative market and then figure out whether it is the perfect bet for you or not.
So, without further ado, let us discuss about the advantages and disadvantages of derivatives and try to figure out whether it is fit for you investment style or not.
2. Advantages of Derivatives:
It is pretty obvious, that derivatives have a great impact on the modern finance because they come with numerous advantages for the financial markets. Some of the major advantages of derivatives include:
Hedging Risk Exposure: As we have discussed earlier, derivative is an instrument which derives it value from an underlying asset and this makes them the perfect option for hedging risks. For hedging, an investor invests in a derivative contract which has an opposite movement on its value to the asset which is owned by the investor. So, in case the investor loses money on his asset, the profits earned on the derivative contract will offset the losses.
Underlying Asset Price Determination: Derivatives are often used in the market for determining the prices of the underlying assets. For instance, the spot prices of the future contracts may be used to get an approximate value of the underlying commodity.
Market Efficiency: Derivatives are often considered to make the financial markets more efficient. Derivative contracts are the perfect option for replicating the payoff of the underlying asset. Thus, there is always an equilibrium between the price of the underlying asset and the associated derivative. This helps to avoid arbitraging opportunities in the market.
Access to unavailable assets or markets: The global financial markets are very vast. It is next to impossible for any investor to have a direct access to every asset or market. Derivatives can help you in gaining access to all such unavailable assets and markets. You can use interest rate swaps and obtain much more favorable interest rates relative to interest rates available for direct borrowing.
3. Disadvantages of Derivatives:
Derivatives are associated with various disadvantages as well, some of which are very significant. Derivatives led to disastrous consequences during the 2007-2008 financial crisis because they led to a rapid devaluation of mortgage backed securities and credit default swaps which in turn was one of the key factors for the collapse of financial institutions and securities. Some of the significant disadvantages of derivatives are:
High Risk : Derivatives are a high-risk instrument. The volatile nature of derivatives can lead to huge losses. Moreover, the contracts are designed in such a way that it becomes very complicated for the investors to valuate them. Therefore, there is a very high inherent risk associated as well.
Speculative features: Derivatives are an instrument which are often used a speculation tool in the market. Derivatives are extremely risky and have an unpredictable behavior. Any unreasonable speculation using derivatives can thus wipe out a considerable portion of your capital.
Counter Party Risk: Derivative contracts are traded on the exchanges as well as over the counter. The contracts which are traded on the exchange go through a due diligence process, however the over the counter contracts does not have any benchmark for due diligence. This leads to a risk of counter party risk.
Conclusion
Almost every other asset or instrument in the financial markets have both pros and cons and derivatives are no different. It requires lot of experience and knowledge to trade in derivatives effectively. If you want to use swing trading strategies to make the most out of derivatives, Delta Derivative Plus can help you. However, if you want to trade exclusively in equity derivatives, Equity Derivative Pack can prove out to be very useful for you. It is better to have your risk appetite calculated from an SEBI registered investment advisor before stepping into the lucrative world of derivatives.
Happy Trading!
