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Introduction and Uses of Derivatives

(Derivatives)Derivatives is a kind of virtual product, which helps trader to do trading in both sides of the market like long and short site of the market.
It is a security with a price, which is derived from one or more underlying assets. It is a kind of contracts between two or more parties for doing business.
It is up different types given below.

  1. Forward
  2. Futures
  3. Option
  4. Swap

(Forward): – It is an agreement between two or more people for some underlying assets, for specific timing period. In this case price of the product is unknown in current period.
Example:
Two persons are doing business. One is a farmer and other person is dealer. Let’s farmer is doing potato business. The price of potato is 20000 per 100kg. But, in coming month, if the price reduced to 15000 per 100kg, then he will make loss. So, Farmer will make one deal with dealer that he will sell his potato to the dealer in some price like 18000/- for two month. And in this case if potato price went down below 18000 in the coming month, then dealer will pay to farmer 18000. But if price increase more than 18000, still dealer will pay the same amount to farmer. In this way both farmer and dealer will make money. This type of agreement concepts is called as forward derivative.

(Futures): – Futures market is a kind of instruments, which helps people do trading in both direction of the market. It is an instrument, which helps trader to buy underlying assets of different products with specified price for specific period of times.
Generally, the futures contracts duration is 1 month or 2 months or 3 months. It has different properties given below.

  • Trade on both the direction.
  • Time period is limited.
  • We can buy shares in term of lot.
  • Un-limited number lots can be buy/sell.
  • You can make money in both the direction.
  • Get discount price product.
  • Only paying margin to buy futures contract.

(Option): – Option is kind of instruments. It helps trader for hedging in the market. By using this product, you can make your own strategy to trade in the market.
• Buying an option, need to pay only margin amount. You will get obligation on that contract, not right.

Moneyness of an Option: – In-the-Money, at-the Money and out-of-Money all these terms refer to an aspect of trading is called moneyness.

In-the-Money: – Whenever you are buying a call, if the strike price is less than the spot price/current price, then this option is an in-the-money call option.
It is opposite at the time of put buying, if the strike price is greater than current price, then it is an in-the-money put option.
Out-of-Money: – Whenever you are buying a call, if the strike price is greater than the spot price/current price, then this option is an in-the-money call option.
It is opposite at the time of put buying, if the strike price is less than current price, then it is an in-the-money put option.
At-the-Money: – The strike price and spot price is almost same.

(Swaps): – A swap is a derivative contract through which two parties exchange financial instruments. These instruments can be almost anything, but most swaps involve cash flows based on a notional principal amount that both parties agree to. Usually, the principal does not change hands.
Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable that is, based on a benchmark interest rate, floating currency exchange rate or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter contracts between businesses or financial institutions.

(Participants in derivative markets) Participants in future/forward markets are day-trader, scalpers, hedgers, speculators, arbitrageurs.
Day-trader: It means who is doing intraday trading. Buying and selling positions in same days.
Hedgers: Hedgers are the actual long time investors. Those people invest their money for long term basic like for 1 yr, 2 yrs., etc. Instead of using stop-loss, they can hedge option product. So if market went down, they will get some amount of money from hedging, instead of losing huge amount.
Speculators:
These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset.
Arbitrageurs: Arbitrageurs are less risk taker in the market. They never want to lose their market. These people always take two positions like buying/selling in the same or different contracts.

(Uses of derivative Market):

  • Derivative market helps trader to earn money from both the direction of the market like long site and short site of the market.
  • It is very useful for market liquidity.
  • It helps to create own strategy. So, investor or trader can make their own strategy to earn money in the market.
  • It helps the investor to keep safe their money in the time of down fall in the market, by hedging.

(Image Courtesy: static.pexels.com/photos/163032/office-pen-calculator-computation-163032.jpeg)

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