Derivatives : Introduction

Derivative word literally means something that is derived like petrol is derived from oil and as such depends on it. In the terms of money market and online trading the derivative means an asset which totally depends on an underlying asset. That asset can be any thing that can be traded online or offline in the market like commodities, stock, currency and even livestock. Derivatives have no independent value. The value of derivatives is dependent on the underlying asset it is representing.

Let us understand the essentials of derivatives and types of derivatives first. Derivatives are broadly divided into two types, options and futures.

Option is a type of derivative through which the buyer of the derivative contract gets the right either to buy or sell the specified quantity of underlying asset, upon which derivative is based,for an agreed price. The time of buying or selling can be on or before the specific future date. One thing to be noted here is that the buyer in question is not under an obligation to do so.

Futures are the derivative contracts which are very different from options. These contracts require one to buy or sell a specified quantity of asset on a particular date, which is also called expiration date, at the current market price. The valid periods for which futures contracts can be done are one , two or three months.

Now that you know about options and futures derivative contracts, you must understand the reason why would anyone trade in derivatives, risky as they are, when there are so many options available. The first reason is that trading in derivatives allows you to take advantage of market swings. If you have an intuition or advice about how market will move you can speculate and make some fast money. The second reason is that enables you to trade even if you have small budget because you do not have to pay the whole price of the underlying asset. You have to pay a small fraction of the whole value.

This is just the tip of the iceberg . There are hell lot of details that should be known so that one can really make some money trading in derivatives. The concept of derivatives is a complex one and in later posts some of those concepts will be clarified.