Derivatives can be used in number of ways depending on trader’s and investor’s risk tolerance capacity and goals. Hedging, speculation and arbitrage are the strategies, which investors use to make profits or reduce risks on their investments.
Hedging
It is a financial strategy used by traders/investors to mitigate the risk of losses that may occur due to unexpected fluctuation in the market.
It is basically a risk management strategy used for contrary situation.
In hedging, investment in one market is protected by another investment in another market and both the investments need to be negatively correlated.
For example, suppose you buy shares of ABC company and expect it to rise or bullish about it, but to protect yourself from the downside, you can buy a put option of ABC Company, which will give you the right to sell the stock at a specific price/strike price for a particular period of time.
Stock price and put option will be negatively correlated.
If stock price goes below the strike price, the loss will be offset by gains in the put option.
Speculation
It is a high risk trading which is done with only one motivation that is taking advantage of market’s fluctuation. Speculative trades are based on calculated guesses.
As these trades are done in one direction only, therefore they are always vulnerable to the opposite side of the market which makes them very risky.
For example, suppose there’s a speculator who is bullish about a certain stock.
He buys a call option with a belief of only upside gains without realizing the downside risks.
Now if he gets successful in his estimates it will gain him, but in case if it reverses which he didn’t protected will make him lose a big amount of his investment or the whole investment.
Arbitrage
It is a strategy, traders use to make profit from price differentiation of one asset in two different markets.
It is a simultaneous process in which there’s a buying of asset in one market where price is low and selling the same asset in another market where it’s price is higher.
It is less risky than speculation, as buying and selling of an asset is in equal amount.
Arbitrage opportunity arises due to market’ inefficiencies to react on certain condition at the same time which leads to imbalance in the price of asset and traders exploit this opportunity.
For example, buying shares of an ABC company and going short in its future contract with same quantity, when the price of the future contract is different but higher than in cash market.
Thanks for reading.
Sakshi johari (Understanding options trading)
Sakshi johari is the writer behind the blog “understanding options trading.com”. She writes blog posts on options trading with the motive to educate people about the various concepts of options trading.
You can read more on options trading at www.understandingoptionstrading.com
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
