Trading derivatives instead of the underlying equity provides a range of benefits and carries a number of risks. Derivative contracts can be used to
- Gain leverage
- Hedge Risk
- Speculate in various markets
- Trade markets where there is, in fact, no underlying equity
- Provide options for purchase or sale in uncertain market situations
- Profit from providing a kind of insurance for other traders
Options and More
Trading options, futures contracts, credit derivatives, forwards, foreign exchange derivatives or interest rate derivatives are all ways to reduce risk. In each case traders learn to use both fundamental and technical analysis to obtain their objective and avoid problems. Because of the high degree of leverage often used in trading derivatives it is possible to earn a large amount of money with a single trade. It is also possible to lose substantial amount of money in poorly thought out trades or over leveraged trades in which the trader does not accept and cut his losses in a timely manner. The Barings Bank disaster in 1995 is a prime example of an options trader trying to cover his losses and waiting for a market turnaround to save him from badly set up sales of options contracts. By the time the trader was picked up by police in Singapore the British bank that had been an institution for hundreds of years was bankrupt! However, if in trading options you remain on the side of the buyer you will commonly limit your risk and still be able to gain handsome profits for your work of analysis and timing of trades.
Interest Rate Derivatives
The biggest market for trading derivatives is interest rate derivatives. An interest rate derivative is the right to receive a given amount of money at a given interest rate. There are interest rate swaps totaling hundreds of trillions of dollars each year. Primarily this market is used by large companies to control their cash flows. Just as the small trader uses technical analysis to anticipate market prices large companies use technical analysis indicators to anticipate interest rate changes.
Trading Derivatives in Foreign Currencies
Trading derivatives also happens in the Forex market. However, trading derivatives is not a matter of buying and selling in a given currency pair but, rather, the use of Forex options, Forex swaps, currency futures, currency swaps, foreign exchange hedges, and binary options.
Hedging Risk by Trading Derivatives
The first and primary use of trading derivatives is hedging business risk. For example, a gold mining operation will sell gold futures, promising to deliver a given quantity of refined gold a year hence at an agreed upon price. In this way the company mitigates the risk of a market reversal in the price of gold. Likewise agricultural producers will sell corn futures, soybean futures, engage in live cattle commodity trading and the like to obtain a guaranteed price on all or part of their anticipated production. Buyers of a commodity will, likewise, purchase options futures contracts in order to guarantee the cost of a product.
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