Through the years, the manner of investing has become a bit too complicated. In effect, various kinds of instruments for derivatives were devised. But if you will look at the history of investment closely, you will realize that derivatives are not a new concept. In fact, it has been existent for quite some time already.
Truth be told, it has been in various applications like in the industry of farming. This usually happens when there is a party that agrees to sell a certain product and another party agrees to buy that product for a definite price on a date that has been set. Most of the transactions before the establishment of organized markets are done through agreements like these wherein the only bond that matters is the one dictated by a simple handshake.
The kind of investment that gives leeway to individuals to sell or buy their options on a particular security is actually called the derivative. These derivatives are classified as investments wherein the investor has no asset that is underlying. Here, the investor actually makes a specific bet in connection with the direction that would be taken by the movement of the price. From the result of the movement, the seller will know if he is going to make some profit out of it or not.
Instruments used for different types of derivative may vary. These include the following, but there are many more not included in the list: forward contracts, options, futures, and swaps. Derivatives are truly very useful but it also presents several risks. Generally, derivatives are considered as an alternative manner of participating in the activities in the market.
Many investors find it difficult to comprehend the idea behind derivatives. But the basic principles can be stated in the simplest terms possible. First, there are different kinds of instruments, each of which have certain counterparty. The counterparty is actually responsible for the movement on the other end of the trading. Each of the derivatives actually has an asset that is underlying. The value of the underlying asset is based upon the derivative’s risk, price, and structure of the basic term. In effect, the risk perceived on the part of the asset actually influences the risk perceived for the derivative.
Mr. Tim, A Senior Forex analyst from Admiralmarkets.ae, says “When it comes to pricing, you might realize that it is a very complicated undertaking. The derivative pricing may call for the need for a strike price”. Hence, the strike price refers to the specified price at which it can be actually exercised. When it comes to the fixed income derivatives, a call price might be existent. Here, the issuer can readily convert a derivative into a security.
At this point, you might be wondering why derivatives are used by investors. Usually, three reasons are commonly given: (1) to do a hedging of a certain position; (2) to increase the leverage; and (3) to effectively speculate the movement of a certain asset.
Finally, the derivatives can be sold or bought in two different ways. There are traders who prefer to do it over the counter. On the other hand, there are investors who do the trader barter style.