Along with equity and mutual funds, there are some other investment options one can go for. Derivatives are such options and can be just the instrument that an investor needs, but first, one must understand how they work. So, what is derivatives anyway?
Derivatives are securities or financial instruments that are derived from another underlying asset or group of assets. They can take several forms. Some of the common forms include futures and options. Swaps, forwards, etc. Different derivatives have different characteristics, and an understanding of the specific nature of the instrument is desirable before making the investment.
Advantages of investing in Derivatives
The following are some of the most important advantages of derivatives:
- Risk management through hedging
Hedging refers to a risk management strategy where one can take a position in a particular financial instrument or asset such that it should offset any adverse fluctuations in price movements for another asset. Derivatives like Futures, Forwards and Options.
- More investment options
Derivatives offer an alternative form of investment that helps investors to make investments more in accord with their reading of the market. Moreover, as mentioned above, there are several types of derivatives available in the market.
- Access to new markets
Derivatives also enable one to invest in assets indirectly that may not otherwise be available for investment (or not with the same comfort). This advantage particularly applies to the commodity market. As the derivatives based on prices of commodities like gold, oil, or food crops can be invested, and thus one can invest to gain from their price changes without actually having to go through the hassle of buying the commodity in question.
One of the biggest attractions of derivatives is the leverage they offer. Since one doesn’t have to pay the entire price, one can deal in way more securities. However, that also makes derivatives far riskier.
Due to the high leverage offered by Derivatives, they are an excellent instrument for speculative investors who can widen the scope of their investment and thus gain more (though the risk also increases).
Derivatives are also an excellent instrument for arbitrage. Simply put, it is when an investor tries to benefit from the differences in prices. The effect of investors doing the same is reducing these differences.
Types of derivatives
The following are some important types of derivatives:
- Futures – Contracts where one agrees to (and is under obligation to) buy or sell an underlying asset at a specific price and date in the future.
- Option – Contracts where one has the option or right, but not the obligation, to buy or sell an underlying asset at a specific price and date in the future. Options Trading is available in most stock markets.
- Swaps – Contract where one agrees to exchange cash flows on a future date.
- Forwards – Like futures, except forward are not traded on the stock exchange.
The Bottom Line
Derivatives can be an excellent instrument if invested in carefully, but they also have high-risk potential and thus should only be invested with discretion.