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Derivatives Trading 101

All those active in the trading world have probably heard about derivatives trading. Typically, it’s more attractive to experienced traders. Of course, this doesn’t mean it comes without risks. Below we are going to explain what is a derivative, how does derivatives trading work and what are the risks associated with it.

What is a Derivative?

The derivative is a term used for anything – a contract, security – that gets its value from its relation to another asset such as bonds and stocks.

Traders usually get into the derivatives trading because it gives owner more freedom than the stock or bond. Derivatives contracts are usually non-binding, offer the possibility to get high leverage returns, and financial gurus love them because they allow the use of advanced trading strategies.

Types of Derivatives

There are thousands of different kinds of derivatives, but the majority of the trading revolves around the key three:

Options

Options are contracts made between two parties to purchase or sell an asset at a given price. This the most common type of derivatives.

Swaps

Swaps give traders the opportunity to trade the benefits of their securities between them. For example, if one investor holds a bond with a fixed interest rate, but is in a business where a varying interest rate could be more profitable. He may enter into a swap contract with another investor in order to exchange their interest rates.

Futures

Futures are somewhat similar to options, although the use of assets is different. Futures are typically used for buying the rights to trade with a commodity, but on the trading platforms, they are usually used for buying and selling of financial securities.

The Risks of Derivatives Trading

The use of derivatives can bring a lot of good, but it’s often an instrument of destruction as well. Below are some of the risks associated with derivatives trading:

Volatile Investments

The majority of derivatives are traded on the open market. This can be a big problem for investors, as the asset’s value constantly changes. Due to this volatility and unpredictability of the negotiated terms between the new owners, it is possible for investors to lose their entire investment in a minute.

Overpriced Options

Putting a price on a derivative can be very difficult as it’s based on the value of other securities. Since it’s already quite difficult to determine a price for a share of stock, it becomes way harder to put an accurate price on a derivative based on that stock. And since there are not as many traders as we have with stocks, there are much larger bid-ask spreads, which can often lead to overpriced derivatives.

Time Restrictions

Probably the biggest reason why derivatives are so risky lies in the fact that every derivative has a specified contract life. After the expiry, they become worthless. If the investment bet doesn’t bring a profit within the specified time frame, traders will face a 100 percent loss.

Scam Potential

Many traders find it hard to understand how derivatives work. Scammers often use derivatives to build complex scam schemes to trick both amateur and professional traders.

Conclusion

While investing in derivatives can seem appealing, it’s quite risky, and it’s definitely not for beginners. If you’re planning to start investing in the derivatives, check all the options and learn everything you can about the derivative in order to minimize the risks.

Use of advanced trading strategies is recommended for those looking to trade with the absolutely minimal risk.