Strategic activities relating to trading and investing.
Futures and Options are ‘derivative products’ in the stock market. Derivatives is a financial instrument which derives its value from an underlying asset. Derivatives can be classified in four types namely forwards , futures, options and swaps. For the purpose of trading only futures and options are traded in stock market whereas forwards and swaps do not form a part of trading. Derivatives are primarily used for two major things ; speculation and hedging. Basically speculation and hedging refers to the strategic activities relating to trading and investing.
Speculation attempts to make profits while hedging is concern with the intention to get into the position to reduce the losses. If hedgers can be characterized as risk-averse, speculators can be seen as risk-lovers. The main purpose of speculation, on the other hand, is to profit from betting in the direction in which an asset will be moving.
Two parties enter into a derivative contract where they agree to buy or sell the underlying asset at an agreed price on a fixed date. This fixed date is termed the Expiry Date in the stock market. The reason for entering such a contract is to hedge market risks by locking the price of an asset for a future date. One party expects the prices to rise, while the other expects the opposite. As a result,one counterpart stands to profit,and the other party bears the loss.
By the term hedging, we mean a technique of managing price risk. It is used to minimize or eliminate the probability of substantial loss or profits due to movements in the price of the underlying asset (i.e. A commodity or financial instrument), suffered by an investor. This is possible only by holding contrary positions in two different markets to counterbalance the risk of loss. Therefore, if there is a loss/gain in the cash position because of the price fluctuations, it can be offset by the movements in the prices of a futures position.
In an attempt to make huge profits, speculators look for an opportunity where they can take advantage of fluctuations in the price of the financial asset. The asset can be stocks, bonds, commodities, currencies, derivatives and other tradable items. They do not trade in any investments randomly rather they take calculated and analyzed risk. The risk may result in bearing the loss of initial outlay in a futures contract or it may turn into rewards.
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