Derivative trading is a type of investment based on an underlying financial asset. Traders use derivatives to speculate on price movements and businesses use them to hedge their risks. There are many different types of derivatives, including stocks, bonds, currencies, market indices, and commodities. This type of trading has both advantages and disadvantages.
Derivatives typically trade for a fraction of their underlying value. For example, a contract to buy 10,000 bushels of corn at $5 per bushel is worth $50, but it may trade for only $10. Similarly, derivatives on stocks are written in lots of 100 shares, so an option to buy 100 shares of an S&P 500 index fund might trade for $2. As a result, these types of trades require in-depth knowledge of the underlying product. In addition, they require careful research and effective strategies to be successful.
Derivative trading is most profitable when the underlying asset moves in a direction that is favorable to the trader. The risk is higher with derivative trading than in traditional trading, but the returns can be very large. When trading on the derivatives market, volatility in specific financial markets is closely monitored. Higher volatility means that the price of the underlying asset moves more dramatically. Thus, the cost of calls and puts increase accordingly.
Another type of derivative trading involves swaps. Swaps involve two parties exchanging a certain debt or asset in exchange for another. The objective of a swap is to balance the risks of both parties. Most swaps involve interest rates or currencies. For example, a trader might swap a variable interest rate loan with a fixed interest rate.