Derivatives are a very useful way of hedging and diversifying risk, and they serve a vital role in our financial system. They can be used to protect your investments against price fluctuations and allow you to take bigger positions and maximise profits. However, there are some risks involved with using derivatives.
Many types of derivatives can be traded in the futures market. One example is the contracts for difference (CFD), which allows traders to speculate on short-term price movements. These are similar to insurance policies, in that they involve trading the difference between opening and closing prices of assets. Unlike traditional trading, however, you don’t have to own the underlying asset. By purchasing or selling a certain number of CFD units, you are buying or selling a certain amount of the asset. For every point the asset moves, you gain multiples of the number of CFD units you purchased.
Derivative trading is much cheaper than trading traditional stocks and bonds, but there are still costs involved. You have to pay additional fees like stamp duty and statutory charges, and there is also a securities transaction tax. Moreover, you will need to account for the money you invest. The frequency of trading also plays an important role in the overall costs of trading. When you make several transactions in a short time span, the cost of the overall trading will increase. Therefore, you should carefully monitor your transactions and make sure that they do not exceed your gains.
Another important risk is counterparty risk, which is an inherent risk of derivative trading. If you trade with many other traders, your risk will increase.