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Monday, 15 February 2010

Stocks And Derivatives

Someone asked me whether am I doing any option trading?

From Wikipedia, the free encyclopedia

What is derivative?

A derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying asset). Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date.

Derivatives are often highly leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

Derivatives can be used by investors to speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g. moves in a given direction, stays in or out of a specified range, reaches a certain level). Alternatively, traders can use derivatives to hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.

Derivatives are usually broadly categorised by:
  • The relationship between the underlying and the derivative (e.g. forward, option, swap)
  • The type of underlying (e.g. freight derivatives based on Baltic Exchange shipping indices), equity derivatives, foreign exchange derivatives, interest rate derivative, and credit derivatives)
  • The market in which they trade (e.g., exchange traded or over-the-counter)

Derivative is a zero-sum game as there is no real assets involved. When one wins someone else has to lose it.

But, stocks are different as they are real soft assets that are created in the stock markets for the purpose for investing while derivatives are created by market makers for the purpose of speculating.

I don't think I am good enough to speculate and win money from others so I would rather avoid it.

Where Does The Money In The Stock Market Come From?

speculation vs investment

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