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Have you heard about derivative trading and wondered what it is? A derivative trading is a form of a contractual obligation between parties that can be two to any number. The subject matter of the contract is an asset and the fluctuations that the particular asset is subjected to. The derivatives can be used to mark the future high and low that particular asset for example a commodity like gold can go up or down to.
What are the assets that are subject to derivative trading?
1. Stocks of listed companies;
2. Bonds, government and private securities;
3. Commodities that can be traded valuably in the market;
4. Currency pairs;
5. The rate of interest and
6. Market indices
Even thought the above list is not exhaustive in nature, it is observed that these are the most preferred subject matter of most derivative trading contracts.
How are derivatives trading?
As far as trading is concerned, there are two ways of trading them. The first one is Over the Counter or the OTC method. The second is trading them at Exchanges just like normal trading at the stock market. Of the two, the over the counter derivative trading is more common place and also more preferred. But since such trading is not regularized and not really standardized the risk to the party that is trading is much higher than in the trading at stock exchanges where there is higher regulation on trading.
Here is why people prefer to trade in derivatives:
Trading in derivatives is flexible and it affords the party enough rope to be able to choose the kind of security that he or she is comfortable with. Apart from this, the fact that the derivatives can be used for hedging against risks or for the purpose of insurance of assets per se is one thing that draws a lot of people's interest towards it. The use of derivatives in speculation market is also on the rise. This kind of trading is particularly helpful in investing in the international markets.
When it was in its nascent stages, derivative trading was actually a way to ensure that there is a co relation between the exchange rates of commonly traded goods in the international market. This was particularly important because currencies from different economic zones had to defer values assigned to them and therefore there was a need to have a platform to assess and account for them uniformly.
With time, the actual purpose of the derivative trading has changed. It is surprising to know that nowadays mundane data such as the weather in a place is also traded upon! Today, trading in derivatives has actually outlived its purpose. But it is still one of the most popular forms of trading. Derivatives as such are never specific but they are a category of security and it is therefore possible there are many forms of derivatives today.
The use of derivatives in the future contracts:
One of the applications of trading in derivatives is in the use of future contracts. Let us explain this with an example. Say that Mr. A has 100 shares of ABC Ltd, a publicly listed company in August 2017. Now A is also apprehensive about the fate of his asset one year from now. There is Ms. B which shows interest in buying A's shares one year from today. So, if A's market value of the share is $5 each and both A ns B contract that B will buy the shares from A of ABC company at the present rate of $5 it constitutes a future contract.
One year later, if the shares of the ABC company have increased in their value at even $1 each, then Ms. B gets advantage over A because she would be able to buy all the 100 shares at the previous year's rate and that is at $5 each against the present value of $6. On the other hand, A has lost out on $100 dollars cumulatively because he had agreed to sell to B at the rate that was prevalent a year ago.'
Forward contracts and derivatives:
A forward contract is also similar to the future contract but the only difference between the two lies in the fact that the derivatives in the forward contract can only be traded over the counter and not at a stock exchange. A contract for difference is also a very popular form of trading in derivatives. It concentrates mainly on global markets and in commodities that have steadily rising and falling prices. If you are interested one of the most prominent of markets today for this kind of trading is cfd trading .
The investor must do his homework before investing in derivatives:
It is important that before you invest in a derivative you must read up and understand all the risks that are associated with this form of trading. There are nuances that you will need to understand before blindly following everyone in trading in derivatives.
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