Options and Derivatives Trading: An Introduction
Derivatives are financial instruments that depend upon an underlying asset for their value. Options and futures represent the two primary forms of derivates traded by investors in the share market. Derivatives and options are both used to manage financial risks. Options are available on a wide variety of securities, assets and commodities.
Types of Derivatives
Derivatives are divided into three types: Futures, Forwards and Swaps. Futures contracts are contracts wherein two parties agree to sell an underlying asset for a fixed price at a set date in the future. Forwards contracts, which work in the same way as futures, involve transactions wherein the terms of the contract, the size of the asset and settlement processes are all customised. Swaps are instruments used by traders to switch from one cash flow to another.
Types of Options
A Call option is an options agreement that allows the investor the right to buy a specific instrument within a set period for a fixed price.
Put options refer to an options contract wherein the owner gains the right to sell a specific instrument for a fixed price at a given date in the future.
Additional Read: Margin trading - Features and benefits
Differences Between Derivatives and Options
A critical difference between derivatives and options is the following: While derivatives are generally legally binding agreements wherein the holders are obligated to meet the terms of the contract, options holders have the right to fulfil the contract but are not legally required to do so.
Advantages of Options
- Options provide increased cost efficiency due to their ability to grant leveraging power. If used properly, options can be less risky than their counterpart derivatives, as options provide financial insurance 24 x 7.
- Options can also give holders a higher percentage of returns as the holder has to invest less while still gaining the benefit of a profitable trade.
- They allow investors access to complex strategies, such as spreads and combinations, to give them an advantage in market scenarios.
Disadvantages of Options
- Options trade can be complicated to understand.
- Options have lower liquidity.
- Buyers of options lose the time value of the votes while they hold them.
- Options are not available for all stocks.
- Information on options can often be hard to find.
- Higher indirect costs apply to options trade.
Advantages of Derivatives
- Futures contracts have stable margin requirements and do not lose value over time. They offer higher liquidity and easy to understand pricing.
- Forward contracts are customisable and offer a complete hedge since they cover the time and the size of the exposure and offer price protection.
- Swap contracts are cheaper, offer longer terms than futures and options, and better match liabilities and revenues for investors and companies.
Disadvantages of Derivatives
- Swaps have lower liquidity, are subject to default risks, and can breakage costs if terminated early.
- Forwards tie up capital as there is no cash flow before expiry. These are also difficult to cancel and subject to default risks.
- Futures are subject to price fluctuations and can significantly devalue as the contract reaches expiration.
Derivatives and options both present potential risks and benefits. A carefully made investment helps, just as a poor investment can lead to financial ruin. Thus, an investor must carefully research and gauge the market for themselves and determine the best place to invest on their own.
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