In a long-only stock market, profits or losses are straightforward: when a share price rises, the investor profits; when it falls, the investor incurs a loss. However, the derivatives market operates differently. Here, profits can be made even when prices decline, and losses can occur when prices rise, as profits arise from changes in the underlying asset's price, regardless of direction.
What Are Derivatives?
Derivatives are financial contracts with a fixed duration, and their value is derived from an underlying asset. Two parties agree today on a specific price for the underlying asset, which can be shares, bonds, currency rates, commodities, or even interest rates. Essentially, any financial asset can serve as the basis for these contracts, provided they settle at a later agreed-upon time.
Example Scenario
Imagine the derivative price of an underlying asset is SAR 10. Muhammad expects the price to drop to SAR 8 in a month, so he sells a contract based on this prediction. Conversely, Nawaf believes the price will rise to SAR 15 and buys a contract.
- Muhammad: When the price falls to SAR 8, he decides to close his position by taking the opposite side at the current market price. His prediction was correct, and he makes a profit.
- Nawaf: His expectation of a price increase does not materialize, resulting in a loss.
Risk Management and Hedging
If you are concerned about potential declines in your asset prices, derivatives provide trading opportunities and hedging tools to manage the risks associated with price fluctuations. A key feature of derivatives is leverage, which allows for profits that exceed the initial investment. However, be cautious: losses can also exceed your investment.
Types of Derivatives
There are two main types of derivatives:
1. Over-the-Counter (OTC) Derivatives: These are non-standardized contracts traded outside exchanges. Key characteristics include:
- Customizable terms based on parties' specific needs
- Limited liquidity due to their non-standardized nature
- Significant counterparty risk as trades are conducted directly between parties without central clearing
- Typically larger contract sizes compared to exchange-traded derivatives
2. Regulated Market Derivatives: This includes futures and options contracts, which are traded in a transparent manner, aiding in price discovery and ensuring fair pricing of the underlying asset.
Importance of Investor Education
Understanding various financial instruments is crucial for investors. It is essential to have a comprehensive grasp of how financial derivatives work and how to trade them effectively. Additionally, being well-informed about the underlying asset and its market performance is vital for efficient contract management and successful investing.
