Individuals enter the financial markets for making good profits over their investments. However, not all the decisions are fruitful. Derivative trading can be a great way of reducing risks associated with continuously and unpredictably changing markets.
Derivatives are financial instruments which possess no independent value. The value of these contracts depends on the values of other financial assets like stocks, commodities, indexes etc. Any modification in the value of underlying assets due to fluctuating market conditions is bound to change the value of derivatives.
Traders engage in derivative instruments for speculating purposes to gain good profits and for hedging purposes. There are broadly four types of derivatives market that are listed below-
1. Forward- Sometimes, Two trading parties enter into a personalised contract called forward contract for the purpose of buying or selling an underlying asset at a pre-decided price at some point in the future. This may not reap profits and is largely done to minimise risks.
2. Future – Future contracts are similar to forward contracts, but are highly standardised and have low counterparty risks associated with them as they are regulated by the stock exchange.
3. Option- This type of contract gives flexibility to the individuals to trade underlying assets and not do the same at a pre-decided price in the future. The buyer or seller is not under any obligation.
4. Swap- A swap contract is a customised and private contract between two parties for exchanging cash flows based on their separate financial instruments.
Inefficient trading can lead to massive capital loss. Traders should avoid making the following mistakes while trading in derivatives –
- Lack of trading blueprint- Building a portfolio without proper trading strategies can lead to great losses. Having clarity about objectives, predetermining the Entry and exit points, reviewing and understanding what works and what doesn’t, revamping strategies, adapting to the continuously changing market conditions, and using the latest instruments and tools etc., can help individuals in becoming successful traders.
- Too much leveraging- Excessive leveraging for taking a big position tends to make the overall portfolio concentrated and can wipe out a great chunk of capital in case of losses. It is essential to utilise the leverage options carefully and take positions as per one’s risk appetite for making sure the portfolio doesn’t take a hard hit.
- Inabilities to control risks – Losses are an inevitable part of the trade. Having money management and proper stop-loss strategies etc. can help traders survive in the market even after a few of their trades fail.
- Lack of discipline – Illogical, emotional or non-disciplined decisions can force the traders to pay hefty prices. For example, the Time frame plays an important role in the case of Option derivatives which are decaying instruments and it is, therefore, important to exit as soon as possible. One must learn the importance of cutting the losses early and riding profits.
- Over-expectation of higher returns- Rationalising return expectations can save traders from taking huge risks that can otherwise lead to great capital loss. Patience and persistence can help in making good Profits.
Summing up- Devising a meticulous derivative trading plan, being disciplined and learning from the actions of other traders can help individuals to reduce the possibility of mistakes, thus saving time and money.