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Derivative Trading Risks

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Publish Date: October 16th, 2019

By: Sandhya Kannan, Head – Content

A derivative is a contract where its value is derived from its underlying asset. The underlying asset can be stock, commodity, bond, currency, etc. In this contract, the buyer agrees to buy the asset on a specific date at a determined price. There are mainly three types of derivative instruments— futures, options and forwards.

Derivatives are known for hedging risk. This is one of the reasons why it is a growing choice among traders. But there are considered to be extremely risky. Before you use these instruments, you need to be aware of the risks involved in derivatives trading.

Market risk

Market risk is the general risk in any investments. It is the risk that the overall market might lose value, rather than one or more security goes out of favour. Factors that cause market risk are economic recessions, economic conditions, shifts in interest rates, political unrest, etc. Before you start with derivative trading, it is very important to conduct thorough research and determine the probability of investment being profitable.

Counterparty risk

The counterparty or the party on the other side of the derivative contract could go bankrupt. Counterparty risk has different names such as credit risk, legal risk, settlement risk, etc. but they all refer to the same risk. When two parties enter into a contract there could be a possibility that one of them may not follow through on the commitment.

Read more: 5 Mistakes to avoid when trading in Equity

Duration limit

There is a contract expiration date in derivatives. As soon as the date comes to due, the contract gets expired. In case, if the investment doesn’t work out in that specific time period, it may result in losses.

Volatility

It is a risk where the underlying security of the contract constantly changes its value. Volatility can effect to an extent where one party ends up losing the entire value overnight due to fluctuations in prices.

Before you deal with derivatives trading, you need to learn to manage these risks effectively. In the world of derivatives, the market is never secure. You have to be a vigilant trader to trade in such an avenue.

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