Derivatives in the share market are a complex and often misunderstood topic. Despite its long history, it is often viewed as a new and risky form of trading. This perception is due in part to the many misconceptions surrounding derivatives. In this blog post, we will explore eight of the most common misconceptions about derivative trading, and provide accurate information to help you better understand this important area of finance. Whether you are a seasoned trader or just starting to explore the world of derivatives on your demat account app, this post will give you a deeper understanding of the role and benefits of derivatives in managing risk and achieving financial goals.
Derivative trading is only for experienced traders: Derivative trading is not only for experienced traders; while derivatives can be complex and risky, you can also use them with proper education and risk management. As a trader, it is important for you to have a solid understanding of the underlying asset, the mechanics of the derivative, and the potential risks and rewards before entering into a trade.This includes understanding the key terms and concepts, such as strike price, expiration date, and margin requirements. Additionally, it is important to have a clear understanding of your risk tolerance, financial goals, and investment horizon before entering into a derivative trade.
Derivatives are always high risk: While derivatives can be high risk, you can also use them for hedging and managing risk in your portfolio. For example, a farmer may use a futures contract to lock in a price for their crop to protect against a potential decrease in market price. Similarly, a company may use options contracts to hedge against potential changes in currency exchange rates.
Derivatives are always used for speculation: As a continuation of the previous point, while derivatives are often used for speculation, you can also use them for hedging and risk management. Speculation refers to buying or selling an asset with the expectation of profiting from a price change, while hedging refers to taking a position in an asset to offset potential losses in another position.
An example of hedging in the Indian stock market using options is through the use of a protective put option strategy. An investor who owns shares of a particular stock but is concerned about a potential decline in the stock’s price can purchase a put option on that stock. If the stock’s price does fall, the investor can exercise their put option and sell the stock at the higher strike price, limiting their loss. This is a way for the investor to hedge against the risk of a decline in the price of a specific stock.
Derivatives are only limited to stocks and commodities: You can use derivatives for a variety of assets, including currencies, bonds, and even weather. For example, an Indian exporter who is expecting to receive payment in US dollars in the future, but is concerned about the fluctuations in the value of the US dollar against the Indian Rupee, can enter into a currency futures contract to hedge against the exchange rate risk.
Derivatives are banned or heavily regulated: While some derivatives were banned or heavily regulated following the 2008 financial crisis, they are still widely used and regulated by governments around the world. Following the crisis, many countries implemented stricter regulations on derivatives trading to increase transparency and reduce systemic risk.
Derivatives are a new form of trading: Derivatives have been used for centuries, with the first recorded use dating back to ancient Greece. Farmers in ancient Greece would enter into forward contracts with merchants to sell their crops at a fixed price at a future date. This allowed the farmers to hedge against the risk of a decline in crop prices, while also providing merchants with a guaranteed source of supply. Remember that the concept of a derivative is a contract between two parties where the value of the contract is derived from the value of an underlying asset. It doesn’t necessarily need infrastructure like stock exchanges.
Derivatives are only traded on exchanges: That said, while many derivatives are traded on exchanges, you can also trade over-the-counter (OTC) between two parties. OTC derivatives are not traded on a centralised exchange and instead are traded directly between two parties. This can increase the flexibility of the contract but also increase the counterparty risk.
Derivatives are always profitable: Like any investment, trading derivatives in the share market can be profitable or unprofitable depending on market conditions and your skill as a trader. Derivatives can be a powerful tool for managing risk, but they can also be complex and risky. It is important for you to fully understand the potential risks and rewards before entering into a trade using your demat account app.