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Anyone who is investing or trading in the financial market knows how risky derivatives really are. ‘Derivative’ is a contract that derives its value from an underlying asset. That means, if the value of the underlying asset goes up, the value of the contract goes up as well, and vice-versa. It seems easy, right? – But, trust me, it is a lot complicated! Here, the underlying asset could be stocks, commodities, or bonds. Within this contract, there are two parties – buyer and seller who agree to buy or sell the contract on a pre-defined price and predefined time. Forwards, Futures and Options are some examples of derivatives.
These derivatives are used for a number of purposes, but mostly for hedging and speculating – i.e. reduction of risk. By entering in a derivatives contract, the trader can allow himself to lessen the risks on his investments and reduce if used properly. But, any misstep, and you can lose the capital that you invested to reduce the risk.
Here, we’re going to discuss the different types of risks associated with derivatives which are as below:
MARKET RISK
It is also known by the general risk in any investment. The derivatives market is no different from other markets when it comes to market risk. It is because the derivatives also rely on the performance of other financial markets which make derivatives investments prone to market risks.
Also, in the derivatives market, traders make their decisions and take positions based on assumptions, technical analysis, and other factors that led them to believe how the investment likely to perform.
COUNTERPARTY RISK
Counterparty risk or counterparty credit risk is also one of the major risks in derivatives trading. It occurs due to backing off of either of parties involved in the derivative contract or going bankrupt. The chances of this happen is high in the over the counter (OTC) trading, which is much less regulated than the exchange trading. Around three-quarters of the derivatives contracts are entered over the counter. That means, there will be involvement of exchange and hence there is a possibility that the counterparty may not fulfil the obligations. However, in exchange trading, the traders can overcome this risk by using only dealers that they find trustworthy.
LIQUIDITY RISK
It is the risk that presents to the traders who plan to close out a derivative trade before the maturity date. Such traders need to consider if the existing bid-ask spreads are large enough to lead to significant costs.
INTERCONNECTION RISK
As you know the derivatives largely depend upon its underlying assets’ performance but apart from its assets, it also depends upon the external factors. In fact, the underlying assets and external factors are all interconnected to each other. The other market can largely influence the derivatives market and vice-versa.
So, the derivatives traders are also exposed to the interconnection risk. If the trader finds himself in such a situation, it is possible, he could lose his entire capital.
Hope, the types of risks we discussed in the above article will allow you to manage your derivatives contract as per the risk exposure and help you in making smart decisions. However, you cannot totally eradicate the market and credit risk but can mitigate by consistently monitoring and analyze the contracts.
In any case, it would recommendable to use experts’ advisory services or a stock market app since the derivatives market is extremely risky and any newbie trader can find himself in a position where he might lose his whole capital investment. There are many best stock market apps in India that you can keep in your arsenal to avoid the mention of risks while trading in derivatives.
Disclaimer – All the above writings are our own technical view, research and not a recommendation to buy/sell! We are not Sebi registered Investment Advisers. Our clients may have position in the above mentioned stocks. We are not liable for any profit/losses. Every person should do their own research before investing/trading or consult your financial adviser.
Note: The article/calls and advice are subject to caveats. Postman News doesn’t bear any losses on these advices as such.
