What you should know before investing in a derivatives market?

If you are an investor and want to equitably manage and tailor your underlining investment goals, you can do so using derivatives. Derivative is a security whose price is based upon or derived from one or more underlying assets. Derivatives is a contract between two or more parties based upon assets. The value of the derivative can be determined by fluctuations in the assets.

The assets can be interest rate, shares, bonds, commodities, currencies etc. For example, stock options are an asset in a derivative since its price is derived from the underlying stock. These financial instruments help you gain profit by betting on the future price of the underlying assets.

Derivatives were originally used by people to ensure a balanced exchange rate. International exchange rates fluctuations needed a mechanism to ensure its stability. Today, however there are all sorts of derivatives even on the weather. Since derivatives are based on fluctuations, the amount of rain or the number of sunny days in a year would be the basis of the contract between two speculators. Derivatives are largely used for speculation purposes. As a speculator, you will seek a profit from the changes in the underlying asset. Derivatives can either be over the counter or exchange-based derivatives.

The participants in a derivative market are of four types. Hedgers, they are traders who want to protect themselves from hiccups in the product market, and therefore participate in the derivatives market. While you have hedgers in the market who want to avoid risk, you also have speculators who embrace this risk. All markets work on the probability that higher the risk, greater the benefits. Therefore, we have speculators who are also a part of the derivatives market since no one else would be willing to bear that risk. In the Indian derivative market, speculators can be of two types- day traders and position traders. Day traders are intra-day traders which implies that they need to complete all their transactions before the market closes. Position traders rely on news, and technical analysis before making their speculations and therefore carry their position overnight or a longer term.

Futures and options are the most common form of derivatives used. Futures is a type of contract wherein the two parties involved agree to buy or sell a set of assets at a specific time agreed upon and for a specified amount. Options are very much the same as futures but the fundamental difference between them is that in an options contract you are not obliged to hold true to the terms of the agreement, it is optional.

If you are planning on investing in the derivatives market, here are three tips you should keep in mind:

1. Demat Account: It stores your securities in an electronic format. It is customised and unique to every investor.
2. Trading account: Make sure you also have a trading account since all your trades will be conducted from this account. It is also linked to your demat account. Your account number is almost like your identity in the market.
3. Margin Maintenance: It is essential in a derivatives market that you maintain the margin amounts carefully. This implies that you cannot withdraw this amount from your trading account until the next trade comes through.

Knowing what to do now, you are fully equipped to make your first move to invest in the derivatives market.