Just as there are stock markets designated for the trading of stocks, there is also a derivative market for derivative trading. There are two primary reasons why an investor would take part in derivative trading. An investor generally purchases derivatives because he/she is either speculating about the future of the economy, or he/she is attempting to protect his/her investments. In many cases, investors will participate in the derivative market in order to protect their investments.
One of the primary purposes of derivative trading is to assist in hedging risk. When an investor takes part in hedging risk, he/she will purchase a derivative from the derivative market in order to decrease the threat posed by negative price fluctuation. Price fluctuation can cause an investor to turn a profit, but just the same, in many cases it results in substantial financial losses. In order to protect themselves against financial ups-and-downs, a business will often sell futures contracts.
Futures contracts, which are common in derivative trading, are often utilized in hedging practices. A company will sell futures contracts to investors in the derivative market. These contracts will detail very specific information about the terms and conditions of the financial agreement between a corporation and an investor.
For example, a futures contract will outline the shares of stock that an investor will be required to purchase and the established price of the stock. The contract will also specify the date on which the contract expires. Therefore, an investor must purchase or sell these instruments by the designated date.
Derivative trading may help to protect corporations and investors against stock value fluctuation. For example, if an investor purchases a futures contract from the derivative market, he/she will obtain a set cost for a specified quantity of stocks. If stock values have increased by the date that he/she is required to purchase the shares, then the issuer will be obligated to adhere to the contract, granting the investor stocks for less than they are currently worth.
If the value of the stocks decreases, then the company will make a profit off of the futures contract, because, unless he/she purchased an option, the investor will be required to pay the strike price for the stocks.
Investors may also choose to partake in the derivative market as a means of speculation. It is a common practice for individuals to attempt to predict the condition of the market. They may try to determine when the value of shares will increase and when they will decrease. If an individual suspects that the stock market will fluctuate, he/she may attempt to take advantage of this through derivative trading.
For example, if an investor believes that stock values will increase, he/she may purchase a futures contract. Therefore, if the price for shares of stock does increase, he/she will be able to obtain the stock at a lower price than its current value, and in turn make a profit. However, this is a risky undertaking. If the price of stocks decreases, the investor will end up losing money on his/her investment.