Derivative trading is an investment strategy in which you can participate in a profit or loss based on the price movements of underlying assets. The risks involved in derivative trading are high because the prices of underlying assets are volatile and can fluctuate rapidly. It is therefore vital for investors to understand the derivatives market before they enter it.
Derivatives are based on financial markets and can be used to hedge positions, provide leverage and speculate on asset prices. Their original purpose was to balance exchange rates, but today, they can be used for a wide range of reasons. Some examples include weather data or the price of grapes. For example, a Spanish investor who wants to buy shares of a British company in GBP wants to hedge his risks by purchasing a currency derivative based on that currency. Because currency prices fluctuate, the investor’s stock may lose value. A currency derivative would help him hedge his risk by locking in a fixed exchange rate.
In addition to hedging risks, derivatives allow investors to gain enhanced profits over purchasing an asset outright. Derivatives have gained popularity since the 1980s, and can be traded on many financial markets.