A Guide To Derivatives: Things to Know Before You Start Trading

Derivatives are a flexible and cost-effective way to limit the risk level posed by your investments. However, to some people, it may be synonymous with the toxic financial instruments which brought the financial crisis in 2008. Though it’s true that the rapid increase of unregulated derivatives has caused the crisis, the instrument itself is supposed safely remove and diversify away from the risks in underlying assets.

Why Derivatives Exist

Financial instruments are usually created to solve existing problems in the market. For derivatives, the problem is the high risk of commodity markets. They are derived from other financial instruments and traded as a product themselves. In other words, their value depends on the underlying asset.

So how does a derivative help in risk management? Simple. You can use it to hedge or speculate a position you want to protect from the risk of disadvantageous move in assets. By hedging, it means taking your offset position with regards to security. This helps mitigate against unfavorable price movements.

How Derivative Trading Works

To learn how derivative trading works, consider this first: A trader can buy currency forward contracts to hedge the risk of loss which may be the result of fluctuations in currency rate. That’s the simplest way to explain why people trade derivatives. However, the process itself is so complicated that it will take time before you can fully understand it. To give you an overview, here’s what you should do when trading derivatives.

One: Develop a trading plan.

Calculate your initial risk and stop loss point. You need to set criteria for your stop loss movement and profitable trade exit for this.

Two: Choose a contract.

Once you are ready to enter the market, you can pick a future. A future is a contract that you buy or sell as an asset for a specific price at your predetermined time. Once you buy a contract, it means that you will pay the asset’s price at a specified time. If you sell a futures contract, you promise to transfer the asset to the buyer at a specific price at your predetermined time.

Three: Open a trading account with a broker.

You can trade derivative Over The Counter (OTC) or on exchanges. OTC trading is a bit risky as you need to privately negotiate with the other party and create your own contract. With exchange trading, you use electronic trading systems to view the prices of different assets.

The Risk of Derivatives

What makes derivatives so dangerous that it caused the financial crisis in 2008? You need to know that by trading derivatives, you expose yourself to a counterparty, interconnection, and liquidity risks. These instruments make use of a contract that derives its value on the financial asset. However, pricing securitized products has been proven to be difficult. When people start selling them and leveraging their positions to reap the highest gain, they become a problem. You can understand this more clearly by reading this article.

Conclusion

It seems ironic that a financial instrument created to mitigate risk can also increase it. But of course, there’s no such thing as a perfect instrument. The best thing you can really do is to calculate your every move, so you will not experience extreme loss.