SHARETIPSINFO >> Articles Directory >>Derivative instrument, How to make money from derivative trading

 

Derivative is financial instrument that is traded at the derivative market. There are some underlying variables that determine the price of the derivative instrument. Derivative trading can be done on different assets including commodity and stocks. Derivative is either traded through the exchange or it can be traded between the two parties. There four types of derivative instruments that are traded in the market – Future, Forward, Options, and Swaps. In respect to the sock market the Future and Options are the two most widely traded derivative instruments. In derivative trading the Future and Options are traded as contracts and they are bought and sold in the form of a lot. The price of the lot is determined by multiplying the number of stocks in the lot with the current price of the stock. The number of stocks in the lot varies from company to company and it is determined on the basis of the price of the stock and some other factors.

Future Contract – The future contract is an agreement between the buyer and seller to buy or sell one or more lot of the stock or index at a fixed rate and on a stipulated date. For buying the contract the buyer has to pay the margin amount that is about 15% of the total price of the lot. This margin amount of course changes every day as the price of the stock fluctuates. Every day the margin amount is determined on the basis of the price of the stock and that is called the mark to market. You can sell the future contract if you have got more than the settled price and you can earn the difference money as your profit. You can also wait till the settlement date to see if you can earn more. But whether you make profit or loss from the deal you have to close the settlement on the stipulated date as per the future contract.

Option Contract – In an option contract as well an agreement is made between the buyer and the seller for one or more lot of the stocks on a fixed price for that option that needs to be settled at fixed date. But the difference between the future and option contract is that unlike future contract the buyer of the option contract may ignore the contract to buy the lot on the fixed date. But if the buyer executes the buying option then the seller is bound to sell as per the contract.

There are certain advantages and disadvantages of derivative trading. The biggest advantage of derivative trading is that you can buy the lot in future or option contract by paying only a part of the price of the lot. In most cases you need to pay about 20% to 30% of the price of the contract. So while trading in derivatives you have the chance to earn more profit by investing less. While trading in derivative you can short sell the lot. That means you can first sell the lot at a higher price and then buy that within the stipulated time at a lower price. So if you are certain that the price of a specific stock will reduce you can earn profit by short selling on the future or option contract.

The biggest disadvantage of derivative trading is that you are abided by a time frame to close the deal irrespective of the fact that you make profit or loss from the deal. So even if the stock does not rise to level that you had speculated you have to sell the lot incurring loss. As you are not investing the total amount you will loose huge amount of money when you are making loss in derivative trading. Remember that all the stocks that are listed in the stock exchange is available for derivative trading so your options are limited when it comes to derivative trading.

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