A derivative is a unique financial instrument. Specifically, it is a contract whose value depends partly, or entirely, on the fluctuations in the values of its underlying components. This means that when an investor invests in derivatives, he is usually really investing a combination of instruments. This means that the value of his contract can skyrocket, if each of its components becomes more valuable. Conversely, his contract value can shrink if the instruments comprising it do so.
Derivative markets are tricky financial instruments in that what investors really buy, and sell, is risk. If it sounds confusing to you, it is. A simplified explanation of the effect of derivatives is that when one investor makes a profit on his contract, another investor loses an equal amount, almost like a transfer of funds – though not exactly so. Contrary to the impression this would give of a negative effect on economic growth, it has been proven that such markets have actually helped to stabilize economies, particularly the American economy.
An example of a trade of derivatives is a futures contract. One investor sells this derivative and the counter-party buys the same. The risk of this derivative has been effectively sold to the second investor, as well as the potential for gain. Such trades usually occur on over the counter markets as no dedicated major exchanges exist for the trading of these instruments.
Though highly complex, trading in derivatives involves no more risk than other comparable investment devices, statistically. There is a much greater potential for financial gain, however, which is part of the appeal of this intriguing, yet difficult to understand, instrument. An additional attraction, to potential investors, is the ability to easily transfer risk from one investor to another, unique to this market.
The derivative markets hold great potential for an investor, providing that he, or she, is savvy enough to take the time to do proper investigation. A common mistake among investors is to get into this market without fully understanding how it works. This means that the investor will not know the signs to look for, and what actions to take when certain situations arise. It isn’t just a matter of selecting a derivative with a good track record. Care should be taken to monitor past performance and determine the likelihood of such performance continuing or changing in the near future. Once this is done, significant financial gains can be had in this market, just like any other.
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