What are derivatives? Understand this complicated market

Anyone who follows the financial market has certainly heard of derivatives. Although they are well known, many people are not sure what they are and how they work.

Generally speaking, derivatives are financial contracts whose final value is associated with another asset, which may be of a physical or financial nature or even the result of a negotiation in the market.

They can be classified in different ways according to their characteristics and behavior.

Derivatives are traded in standardized contracts with specifications that guarantee the transfer of risk of changes in the prices of the assets that are used as the basis of the transactions.

And although they are widely used as a risk protection and management mechanism by companies, it is possible to invest and profit from them.

Don’t you know how? Don’t worry. In this guide, you will find the concepts that involve this type of negotiation, how they work, and much more:

What are derivatives?
What are the main types of derivatives?
What are derivatives for?
Is it worth investing in derivatives?
Conclusion

What are derivatives?

Derivatives are financial investments that ‘derive’ from other market quotations. This means that they are completely associated with another asset, and their yield and liquidity depend on its value.

Derivatives are financial instruments whose market price results from the market price of an asset or other financial instrument other than the original.

Therefore, its value varies according to the behavior of that other product, and when purchasing it, there is always a price and deadline established for a pre-defined future date.

Therefore, a derivative is a financial product that oscillates according to another product. It has its own quote, which is backed by another asset.

It’s a complicated market to understand. In practice, it’s simpler than it looks.

Imagine you purchased a derivative linked to the foreign exchange market. In this case, its valuation would be in accordance with the dollar exchange rate. In this way, you did not purchase the currency but the right to its oscillation.

What are the types of derivatives?

There are three types of derivatives that are classified according to their characteristics and market behavior.

There are those who consider the SWAP market to be a fourth type of derivative. In this text, we will focus on the main ones.

Forward Market

A forward market, or a forward transaction, is a type of derivative in which the buyer and seller agree to buy or sell assets at a future date. In this way, the two are linked to each other until the purchase or sale is carried out.

The value of this operation is determined in the negotiation, but the settlement of this same amount will only be charged on a future date predetermined by both parties.

For example, companies often sell shares for 30 days. In this case, the investor undertakes to buy these shares at the end of that period of time for the amount previously agreed upon. Likewise, the company is obliged to sell its shares.

Futures Market

The operation of the futures market is similar to the forward market. That is, contracts for the purchase and sale of products that will only be carried out in the future are negotiated.

The difference is that, in the forward market, the price negotiated at the beginning of the operation is fixed. In the futures market, the value is adjusted according to the passage of time until the settlement date of the asset.

In this way, futures market contracts undergo daily adjustments. This means that as long as you own them, you need to realize profits and losses every day.

In this market, the investor can buy a contract for the sale or purchase of an investment at a given price and date. Being in possession of it, he can sell the contract to another investor before the end date of the operation. This allows greater liquidity for the asset and gives freedom to the investor.

Options Market

In the options market, trading is carried out on the right to buy or sell a certain asset at a fixed price on a future date. That is, the buyer or seller is under no obligation to make the purchase or sale.

However, prices and deadlines are predetermined at the beginning of the operation.

In this market, the holder of the derivative always has the right to purchase but is under no obligation to exercise it. The seller, on the other hand, has an obligation to assist the buyer if he wants to do so.

What are derivatives for?

Derivatives can be used in many ways in the financial market. The main use of this feature is to protect your investments and leverage your profits.

A derivative can be used with the aim of protecting an asset from fluctuations that may occur in the future, as it allows fixing the value of a commodity or a financial service in advance, which reduces the impact of an eventual change in market prices.

The term used to refer to this operation is the hedge. Hedgers are more interested in avoiding losses than in profiting from trades.

On the other hand, it is possible to invest in derivatives with the aim of generating profit. Whoever performs this type of operation is called a speculator. His gain is in the small price differentials in the acquisition and sale of each derivative contract.

For him, the nature of the derivatives does not matter. His interest is not in the underlying assets but in the profit that the operation generates.

Is it worth investing in derivatives?

Investing in derivatives is not an easy thing. This is a complicated market that requires a lot of study and attention to the main trends in the financial market. Studying and practicing a lot is essential to succeed in this type of trading.

Before you include it in your investment portfolio, make sure you have the profile to become a derivatives investor. It is a high-risk investment in which you need to know what you are doing, why and for what.

If you decide to invest in derivatives, know that the big advantage of this type of investment is the possibility of investing in any market trend, whether high or low.

They are also a way to diversify investments and make your portfolio safer. This is one of the main secrets for anyone who wants to succeed in the financial market.

On the other hand, derivatives can increase losses. Therefore, never invest in this market without first visualizing the complete scenario of your investment. Anticipate the worst possible situation and be prepared for it.

Conclusion

Derivatives are a great option for investors who want to diversify their investment portfolio and seek new horizons and opportunities to make a profit.

Before venturing into this complicated market, be aware that derivatives trading is not the trading of assets per se but the contract that entitles you to fluctuations in the values they generate. By definition, they are financial investments that ‘derive’ from other market quotations.

It is also important to know the three main types of derivatives: forward market, futures market, and options market. Each of them works in a different way and can generate profit according to market behavior.

They can be used to protect your investments and also leverage your profits. By being associated with another asset, it can guarantee some stability for your finances and make them increasingly liquid.

Bear in mind that investing in derivatives is complicated and requires a lot of study and practice, as well as a clinical and attentive eye for the main market trends. It is never too late to gain knowledge and, consequently, diversify investments and make your investment portfolio safer.

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