What are DERIVATIVES

Last Updated on

What Are Derivatives

Who uses derivatives markets ?

Well businessmen obviously, but in this type of market they are divided into 4 groups. These are hedgers, speculators, margin traders and arbitrageurs.

Each group has its own motives and reasons for trading in this type of market.

Hedgers are traders aiming to protect themselves from the risks of price movements. They are called hedgers for a reason, because they try to hedge prices of their own assets by doing the opposite trading in the derivatives market. This is very convenient for them because they pass risk to people who are willing to deal with it.

Speculators are those who take risks that Hedgers want to dispose of. I know what you are thinking right now – why would someone willingly take risks? Well, there is an excellent explanation for that. In business, there are clear rules and one of them is the bigger the risk you take, the higher the profits you might earn. So it becomes clear now, right?

Speculators will willingly take risks that hedgers want to get rid of and plan and hope to succeed in obtaining profits, so if the risk is higher it makes it even more desirable.

Margin traders are those who do trade using a payment system unique in derivative market called margin trading. When they trade in derivative products they are not required to pay the full amount in advance. So they can only leave a deposit, a small amount of the total sum, which is called margin.

So, with a small deposit it is possible to maintain a large position.

Arbitrageurs research imperfections in markets such as difference in prices of stocks in the cash market in comparison to those on derivatives market and use them for their own benefits. Their trade represents low-risk trade. They act in situations when same securities are listed at two markets, but with different prices.

What is Derivative Trading ?

First of all you need to know what is derivatives trading to be able to understand Stock Derivatives Market. Derivatives are financial contracts that derive their value from underlying assets. They include indexes, commodities, currencies, stocks, exchange rates. They were introduced back in 2000 and their popularity has insanely increased ever since.

What is the use of Derivatives ?

For this you need to understand how their entire system works. As we already said, they derive from underlying assets whose value can change very often and unexpectedly. Since among these assets can be currencies or interest rates their value can either increase or decrease, or like in the case of stocks, their value can also jump or fall. All this causes different results.

Thus, it is possible to profit from stocks, indexes, currencies, etc., but I’m sure most of you know they can also create losses. This is when it is useful to pull derivatives that can act as a safety net or help you mitigate losses or even create additional earnings.

How to do trade in derivatives markets?

First and most important – make sure you do your own research! Keep in mind that this type of market requires completely different strategies than the stock market. Be very careful when selecting stocks, obtain margin amounts and conduct trade and good luck!

Library Studying Tran-Tim Tran studies for his ECE 419 final at the University Library at Cal Poly Pomona March 19, 2013.

Author details

Bill Willson is author of this article. He is a professor at California State University. Bill works at neural network for stock prediction.