What is the Meaning of Derivatives Trading in Stock Market?
Derivatives as financial instruments depend upon underlying assets for their value. These instruments have been traded in markets throughout the ages. The history of Derivatives trading has step by step evolved in range and complexity, laying down what would become the foundation of the modern trade in Derivatives that started in the 1970s.
What is Derivative trading?
- Derivative trading is the purchase or sale of Derivatives in the share market.
- Trading in Derivatives revolves around the agreement between the trading parties to trade Derivatives in future for a predetermined price.
- Derivative trading usually happens according to the business hours of the share market.
What are the requirements for Derivatives trading?
While trading in Derivatives is similar to other kinds of trading, there are some requirements that traders must fulfil before they can begin trading in Derivatives:
- Traders are required to have an active demat account which is the account that stores securities in digital format.
- Traders must have a trading account through which the actual trade is conducted. The trading account is linked to the demat account and acts as the trader's identity in the share market.
- Traders must deposit and maintain a fund which is a percentage of the total value of the underlying asset and the calculated price fluctuations. This process is called margin maintenance, and traders must do so daily as per price fluctuations.
Participants of Derivative Trading
Not all traders participate in the trade of Derivatives trading for the same reasons. Based on their goals, traders participating in Derivative trading can be broadly categorised into the following:
- Hedgers are risk-averse traders who trade in Derivatives to protect themselves from price fluctuations. They do so by fixing the price of an underlying asset and transferring risk associated with price fluctuations to risk-oriented speculators.
- Speculators are risk-oriented traders who take risks from Hedgers to profit from price fluctuations. They form an essential source of liquidity to the share markets.
- Arbitrageurs are low-risk traders who attempt to profit by selling the same asset for two different prices in two other markets.
Benefits of Derivative trading
Trading in Derivatives presents different benefits that can meet the needs of various investors:
- Trading in Derivatives involves lower transaction costs than in other forms of trading as the Derivatives act as risk management tools.
- Derivative trading can be a valuable tool for protection against price fluctuations as such fluctuations are already factored into contracts.
- Trading in Derivatives allows investors arbitrage opportunities to gain higher profits through speculations on price differences and fluctuations in different markets.
Drawbacks of Derivative Trading
While trading in Derivatives presents significant benefits to traders, they also have significant drawbacks which must be navigated for a successful trade:
- Derivatives are susceptible to price fluctuations, which can lead to severe loss if not managed properly.
- Contracts in Derivatives trading are challenging to break before expiration, which leaves traders vulnerable to market uncertainty.
- Trading in Derivatives requires extensive knowledge of complex processes of the financial markets, which makes it restrictive.
Derivative trading represents the more complex segments of financial trade, requiring expert knowledge and skill in gauging probability. While such requirements might deter some investors, others have embraced this particular class of trade, eager to take advantage of its opportunity. The digital nature of such trade makes it likely that it will continue to grow in the future as technology keeps advancing.
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