Knowing The Basics Of Derivatives

Knowing The Basics Of Derivatives

A financial contract which derives its own value from the underlying asset is known as derivative. The buyer makes an agreement to buy the assets at a particular price on a particular date. Basically, the derivative is associated with commodities like gold, gasoline or oil. Also, it is associated with currencies.  Nowadays, the trading of currencies could be easily done with the help of trading bots such as bitcoin trader which has been able to create wealth for its user in a short period of time.

In the case of derivatives, the seller of the contract need not have to own any underlying asset. He could just fulfill then derivative contract by handing over the money to the buyer to purchase the asset at the prevailing price. Or else, he can buy another derivative contract which will offset the first contract’s value. This characteristic makes the derivative easier to trade as compared to asset itself.

Mostly the derivates are traded between the traders or organization that personally knows each other. Hence these are called OTC or over the counter transactions. Also, they are traded with the help of an intermediary mostly a large bank. Only 4% of the total derivatives in the world get traded on exchanges. These exchanges which are public set contract terms that are standardized. They set the discounts or premiums on contract price. This standardization helps in improving the derivative’s liquidity. It is more helpful for the hedging purpose.

Risks of trading in derivatives

The derivatives basically have four huge risks:

  • It is quite impossible to know about the real value of the derivatives- The value of the derivative is based on the value of the underlying security which makes it complex to know about real value.
  • Leverage- The future traders are required only to put few percents like 2 to 10% of contract value into the margin in order to maintain ownership. If the underlying asset value drops, then they need to keep adding money to margin account in order to maintain the contract. If the value keeps dropping, jut covering the margin account will lead to huge losses.
  • Time restriction- As there’s a specified time limit is set when the contract is made, it makes it risky to hold onto to the agreement for quite a long period. No one is certain what will happen in future.
  • Potential for scams- Fraud is very much prevalent in the derivatives Hence you need to be very much cautious while dealing with derivatives.