Hedging is a popular practice among investors for insurance against price movements. Derivatives are essential for investors interested in hedging, price speculation, and other practices. Derivatives help investors find momentum even during adverse price movements. Beginners or new investors must fully understand the advantages of derivatives before building their portfolios. Continue reading to know more about the benefits and drawbacks in detail.
- What are Derivatives?
- Advantages of Derivatives
- Conclusion
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What are Derivatives?
Before delving deeper, you must understand the meaning and advantages of derivatives. You might have come across financial contracts like futures and options. These financial contracts are called derivatives , and their value is based on an underlying asset. The underlying asset determining the value of the derivative can be an index, security, or interest rate.
Derivatives are mainly futures, options, or swaps in the financial markets. Futures allow investors to buy or sell the underlying asset at a fixed price (pre-decided) on a given future date. However, futures contracts must be carried out on the expiration date. Investors wanting flexibility choose options, as they don’t offer the obligation to buy or sell the asset on the expiration date. Swaps are derivatives used by two parties to exchange financial instruments, including payouts or cashflows. Let us now understand the risks and benefits of derivatives.
Advantages of Derivatives
Here are some benefits of derivatives you must know:
Essential for Hedging
Investors need to secure their portfolios against adverse or sudden price movements. Financial markets can witness disruptions and adverse price movements due to numerous reasons. Without considering future price movements, investors open doors to potential losses. Derivatives can help investors secure their assets and earn profits even during adverse price movements. For instance, you can invest in a derivative whose value moves in the opposite direction of the asset you own. It will help offset losses for the asset during adverse price movements. Derivatives can help enjoy profits, irrespective of the direction of the price movement.
Improves Effectiveness of Financial Markets
Did you know that derivatives are essential for the proper functioning of a financial market? Derivatives are designed to replicate the payoff of different assets. Derivatives allow investors to find the actual worth of an underlying asset in the market. Since derivatives allow price corrections through arbitrage, investors can determine the actual worth of their assets. Achieving price efficiency might be difficult without the existence of derivatives. Similarly, maintaining equilibrium in the market can be difficult without derivatives.
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Availability of Non-Binding Agreements
The choice of futures and options is among the best advantages of derivatives. You can invest in a futures contract to buy/sell the underlying asset on a future date. You are obligated to carry out the contract on the expiration date. However, some investors might be interested in non-binding agreements that do not obligate the investors to take action on the expiration date. Luckily, investors are blessed with the options contracts. These contracts are non-binding and can be ignored on the expiration date. Non-binding contracts are essential for beginners in the market. It allows them to carry out their investment strategy without risk of obligation.
Multifold Returns
Despite its risks, derivatives have the potential to provide multifold returns. It might even offer extreme returns in some cases. The same is not the case with other financial instruments in the market. You can do much more with derivatives besides hedging. Many investors enjoy high returns by indulging in price speculation through derivatives.
Additionally Read: Demat Account Definition
Access to Diverse Assets
Derivatives offer investors access to diverse financial instruments. These financial instruments might not be available for all investors in traditional markets. For instance, investors cannot interchange their interest rates in a financial market directly. However, they can do so by choosing swaps based on interest rates. Similarly, derivatives offer access to commodities , currencies, stock indices, and other assets.
Now that you have understood the benefits of derivatives, let us discuss the risks or cons:
Disadvantages of Derivatives
Risk Involved
Derivatives can be highly risky, especially during increased market volatility. Since derivatives are usually traded in open markets, their value changes due to numerous factors. The price might constantly change, thus confusing the investors. Not to forget, investors must carry out their futures contracts even if it ends in a loss. However, the issue of obligation can be resolved by investing in options.
Fewer Interested Parties
Derivatives are gaining popularity but aren’t as common as some assets. For instance, most beginners in the market still start by investing in shares. Investors in some countries are more interested in mutual funds and ETFs. Not to forget, there are bonds and commodities in several markets for investors. However, the number of players in the derivatives market will continue to rise in the future. Additionally, opening a new demat account specifically for trading derivatives can be a prudent step for investors looking to diversify their portfolio and capitalize on the potential of these financial instruments.
Contract Life
Every derivative will have an expiration date. The expiration date of a derivative might compel the investors to take action. Other investments like shares and currencies are not time-bound. It is essential to fully understand the time frame of a derivative before investing.
Too Complex for Beginners
Derivatives are more complex than other financial instruments, like shares, mutual funds, and ETFs. Beginners might find it challenging to understand how derivatives work in the market. For the same rationale, many beginners opt out of derivatives. However, you can minimise portfolio risks once you understand the significance of derivatives.
Conclusion
Beginners in financial markets need to understand the advantages of derivatives. They are financial contracts widely used for hedging, price speculation, and price efficiency. Besides understanding the benefits of derivatives, don’t forget to address the risks. You must explore different derivatives like options, futures, and swaps to achieve your investment goals. Learn more about the types of derivatives now!
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