Financial markets are subjects to volatility. The price of securities, commodities, and currencies, among others, fluctuate due to the market volatility. In order to combat these fluctuations effectively, investors deploy numerous strategies to avoid losses. One of the most popular strategies to reduce the risk of market volatility is hedging.
It is a known fact that derivatives are widely used for hedging. The value of this financial security is obtained because of an underlying asset or a group of assets. Based on the price fluctuations of the underlying asset, the value of the derivative also changes.
A major benefit of derivatives is the minimization of risk. It transfers risk from those opposed to the risk to high-risk individuals. Besides, it helps determine current and future prices. Moreover, you may enjoy increased savings and investments in the future.
Types of derivatives
It is important to understand the various types available in the derivatives market. Following are the four most common types.
Simply put, future trading is a contract to sell or purchase a security at a predetermined price at a specified time at a later date. Based on the underlying asset that is being traded, future contracts detail the quantity and quality of the security. Future contracts trade on futures markets and are subject to a daily settlement procedure.
Options trading is a contract wherein the buyer does not have the obligation, but the right, to sell or purchase a security at a pre-determined price on a particular date or during a certain period of time. There are of two types of options – put option and call option. Call options offer the buyer the right, but not the obligation, to purchase a security at a pre-determined price during a certain period of time or on a specific date. Puts, on the other hand, offer the buyer the right, but not the obligation, to sell a security at a pre-determined price during a certain period of time or on a specific date.
Swap is a contract to exchange future cash flows based on a prearranged formula. There are two common types of swaps, namely interest rate and currency swaps. As the name suggests, interest rate swaps indicate swapping the interest cash flows of the same currency. Currency swaps, on the other hand, involves swapping the interest and the principal of equal value in another currency.
A forward contract is a customized contract between a buyer and seller, where they buy or sell a security or commodity at a later date at a price agreed upon today. Securities traded in a forward contract generally include precious metals, commodities, and natural gas, among others.
You may, therefore, use the above-mentioned types to tackle hedging effectively. You may use futures and options, the two most common types of financial contracts, to trade on the stock exchange market.