The word “Derivatives” refers to a variable that has been derived from another variable. Similarly a financial derivative is something that is derived out of the market of some other market product. Hence the derivative cannot stand alone. Its value depends on equity, Interest rate, and commodity and on currency. This product in derivatives is known as underline asset.
As we all know capital market comes with very high degree of risk and volatility. Derivative products can be used to partly or fully hedge the impact of volatility in the asset prices. Nowadays many investors invest money in derivative segment and India is one of the largest derivative markets in the world.
The derivatives products can be categorized into the following main types:-
- Forwards
- Futures
- Options
- Swaps
- Warrants
Let me explain derivatives by real time example…
Say, you go to a car showroom to buy a car. After searching around you decide on a model which costs Rs. 400000/-. The showroom owner says that he would take delivery after a week if you place an order with small initial token money today. Once the showroom owner delivers the car you are expected to pay the full amount. This is effectively a “forward” contract where you are agreeing to the terms of delivery and a payment in future date.
Say, you go to another showroom to buy a car .After searching around you decide on a model that costs Rs. 425000/-. Though you like the model and sure if this is the best model for you and at the same time you are predicting the price of car to come down in one week, thus you talk to owner to put aside this Car for two weeks so that you can arrange cash and come for purchase. The showroom owner in return asks for small non refundable deposit which you pay to block the car in your name. If the price of the car falls then you may not opt to buy the same car but if you want you can always walk into the showroom after the few days makes the payment and take the car. This is “option” contract, wherein you have the option of executing at it your will & wish.
The showroom owner took the non refundable deposit, which is to compensate for the few days that he may have to hold on to his item without selling it. Even if you do not go to buy the car he would have made a meager profit.
HERE ARE SOME TIPS TO MAKE MONEY:-
Indian equity market is most volatile market in the world & hence derivative can be used to protect the investment. So it is very difficult to earn profit on derivative position. Earning profit is difficult & making loss is easy.
3 Aspects of successful trading are;
- Charting and Entry technique
- Money and Trade technique
- And trading psychology.
Some important points to remember:-
- Market will not behave certainties or the way you want, be prepared to handle its volatility.
- Trading in derivatives is RISKY; do not trade them if you don’t understand them.
- You should be prepared to cut losses or take small losses in order to earn large profits.
- There are times where you will not get opportunity to trade.
- Never create any assumption that market will give you fixed monthly income or can be a substitute to your regular job or business.
- Always trade with an amount you can afford to loose.
This blog is written by Sachin Kumar, Nishu Gandhi, Nishant Chauhan and Akansha Mahajan, students of Post Graduate Diploma in Financial Planning (PGDFP), International College of Financial Planning (ICFP).
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