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What are the Best Tips for Trading Derivatives?

Jim B.
Jim B.

Trading derivatives is a practice used by investors in which they buy and sell contracts to purchase some sort of underlying asset like stocks or bonds. Unlike equity trading, in which the investor actually owns the physical asset, derivatives allow investors to speculate on the performance of those assets without owning them. Investors should use trading derivatives as a way to hedge risk and make short-term investments. They also should be aware of the risks involved with what is a relatively complicated method of trading.

When many people think about investing money, they think about it in the traditional sense of buying shares of companies on the stock market. There are other ways to invest in the performance of those companies or many other types of measurable assets without actually getting ownership. Contracts like futures and options are the most common method for trading derivatives, in which a buyer and seller agree upon a contract for an underlying asset to be executed at some point in the future. These contracts have values all their own and may be bought and sold as such without the contracts ever being exercised.

Businessman with a briefcase
Businessman with a briefcase

For this reason, investors can use trading derivatives to accent their portfolio in ways that traditional stock trading is unable to achieve. Hedging against risk is one common way to use derivatives. As an example, an investor might have a significant amount of shares in a certain company's stock. By purchasing a derivatives contract that bets against the good performance of that stock, he can minimize the risk of the stock doing poorly.

Options trading is an increasingly popular way of trading derivatives, but investors need to realize what is at stake when they get involved in this process. The buyer of an option must pay the premium for the contract, but that is all she risks in the investment, while the possibility for profits is technically limitless. On the other hand, the seller of an option puts nothing up at first and can pocket the premium if the underlying asset moves in his direction. If, however, the price moves the way the buyer predicts, the seller can lose a great amount.

Since all investing is risky and the process of trading derivatives is somewhat complicated, investors should try to gain as much expertise as possible before proceeding. One way to do that is to study the derivatives market closely for a good period of time before making investments in it. Another way is so-called paper trading, which occurs when potential investors make imaginary trades on a simulated account to get used to the way the market works.

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