What is Derivatives Trading?
Just like trading in the stock market means buying and selling of, say, stocks of Apple Inc., derivatives trading means buying and selling of derivatives of stock of Apple Inc. When a trader is trading in futures, or call options, or put options of Apple Inc., he is trading in derivatives of Apple Inc. To understand, we took the example of stocks, but for derivatives, securities could be Stocks, Indices, Commodities, Foreign Exchange, Interest rates, Bonds, etc. Let us see in detail the types of derivatives traders.
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Types of Derivatives Traders
There are 3 main types of derivatives traders –
They differ from each other due to their style of trading, their goals and motives, and the difference in the level of risks they undertake.
Let us have a look at these types of derivatives traders in detail.
Hedgers use derivative instruments only to insure against adverse movement of the market. For example, an importer of iPhones in India has to pay 1 million dollars after 3 months for a consignment. Since currency prices keep fluctuating, the buyer hedges his position by booking a forward contract for buying 1 Million Dollars at the end of 3 months at the rate of 70 INR / USD. He is now sure that he will pay 70 * 1 Million = 70 Million INR to pay off the liability of 1 million USD after 3 months. Now, price movements on either side would not impact his transaction value adversely.
Let us understand with another simple example what hedgers do with the help of a derivative. Suppose Mr.X buys 100 shares of a company ABC at $50 per share. He needs to pay for his son’s admission to a college after a period of three months. He is risk-averse and decides to limit his risk in the investment by buying a put option having a strike price of $48 after a three-month period. The put option cost him $1 per share or $100 in total. Thus, he ensures that he will get at least $48 per share at the expiry of the three-month period and can pay comfortably for college admission.
Now suppose that the price of the share falls to $40 at the end of the contract period. He will exercise his option. His losses will be limited just to $2 per share ($50 – $48) + $100 charge for the option, which will be equal to $300. Without the put option, he would have suffered a loss of $1000 ($10 x 100 shares). Also, in case the price of the share moves higher than his purchase price of $50, he need not exercise his option. Therefore, he can hedge his risks with just a payment of $100 as charges of the option.
Speculators are another type of derivatives trader. They operate to make quick profits at the cost of high trading risk. They trade on the basis of speculations and estimations of future prices and enter into positions. Speculators take the high risk so as to earn high gains from the market in a short period of time. It is not that they blindly enter into trades and contracts. The speculators who intend to stay in the market for a long-term device and use investment strategies that suit their style. They gain and develop skills and expertise over a period of time to handle such trades.
For example, let us take the case of Mr.A, who has been an experienced speculator in the market for many years. The stock of Company X is currently trading at $75. He gets an information from some sources that the stock is going to go down considerably in the coming days due to a possible change in the management. He buys a put option on the stock at $72, expiring in 30 days from the present date.
As per his belief, the stock does tank, and at the end of the contract period, it is trading at $65. Theoretically, he buys the shares at $65 and sells them at $72 by exercising his put option. He makes a considerable profit of $7 per share ($72 – $65) without actually buying any share at the beginning of the contract. In case the price is higher or equal to the strike price at the time of expiry of the contract, such speculators may simply exit their position. The only loss they will suffer is the charges for buying the put option. Why do we use the word theoretically? Because most of these obvious settlements are automatically carried out by the exchange in question.
Arbitrageurs are traders who trade to benefit from differences in prices, rules, and regulations between different markets. They use knowledge and information power to figure out the inefficiencies existing in the market and make profits from the situation. They simultaneously execute a trade between two markets before the market inefficiency is corrected by market forces. Also, they need to act fast before other participants of the market find out the inefficiencies, trade on it, and normalize the situation. Such trades are mostly risk-free in nature.
Arbitrageurs look for opportunities when an asset is trading at two different prices in two indices or markets. They buy the asset from the market in which its price is low and sell it in the market at a higher price. The difference between the two trades is their profit. These assets can be a stock or a bond, commodity, currency, or similar other financial instruments.
Generally, the price difference of an asset between two markets is just a few cents. For example, a stock may trade at $10 in one exchange and at an equivalent USD value of 10.05 on another exchange in some other country. An arbitrageur can immediately make a profit of 5 cents on every share he can purchase. Also, he needs to execute the buy and sell simultaneously before the market forces correct this inefficiency. Hence, arbitrageurs need large piles of liquid money to take benefit of the situation instantly and make good profits out of it.
Frequently Asked Questions (FAQs)
Arbitrageurs are required to quickly identify the inefficiencies in the market and act on them before the situation gets normal. When the asset is trading at 2 different prices in 2 different markets, arbitrageur buys asset from where the price is lower and sell in the market where price is higher.