How derivatives acts as a risk management tool ?
Risk is a condition when there are chances of getting unfavorable outcome or something which is not expected . While trading in stock market risk can to be completely eliminated or neglected, however it can be controlled to certain extent.Primary motive of traders to trade in futures is to hedge against future price risk. They often seek advises from market analysts for stock futures tips which can facilitate them in earning their required returns.
Derivatives are contracts whose value is derived by the underlying assets. These assets can be anything like equity, commodity, exchange rates, interest rates etc.There are basically four types of derivative contracts: Option, future, forward, swap. Adding a derivative contract in your portfolio can offer global diversification and can also help to hedge against inflation.
Following are the most widely recognized benefits of derivative contracts :
1)Discovery of price:
Future market prices strongly depends on flow of information .Price fluctuation which we witness are the outcomes of various factors. As we know market discounts every information these price fluctuations are also the result of this nature of market. Information like change in political conditions, government rules and regulations, environmental change, change in demand and supply nature and many more are responsible. As soon as these information hit the market price fluctuations can be seen.And this entire process is termed as price discovery.
2)Risk management tool :
Traders enters in to derivative contract to serve most important purpose of risk management. By risk management we mean that identifying desired risk and then identify the actual level of risk and then framing a contract which can facilitate in reducing the effects of actual risk.
There are two types of participants here: hedgers and speculators. Hedgers define a particular trading strategy and holds a position in market thereby reducing the effects of risk. On the other hand speculators simply take the position they believe market will move.Hedging , speculating and derivative helps traders to deal with risk factor.
Above discussed are the most important benefits which derivative contracts offers. Traders who can really gain benefits from trading in derivatives must have the capability to fully understand the risk associated with the derivative contracts. These risks includes: counter party risk, operational risk, legal risk, liquidity risk and more. Entering in to derivative contract will only make sense if a traders is aware of these different risks .
Also there are financial advisory services providers who can guide you to manage risk using derivative contracts. Here contracts can be designed in number ways. It depends what returns your are expecting and how much risk you can face. Derivatives assist traders to cope up against futures price risk by enabling them to enter in to a future contract at pre decided price and expiration date on which both the parties buyers and sellers agrees.