Trading in the derivative market, which allows investors to speculate on the prices of assets without gaining physical ownership of them, requires timing and the ability to predict price movement. Buying the two most common types of derivatives contracts, options and futures, allows investors to make a relatively small investment with high profit potential. Sellers of derivative contracts should be ready to protect their investments by attempting to get high premium payments and by hedging against losses. There are many different pricing models which allow investors to get a general idea about the worth of contracts on the derivative market.
When individuals invest in the stock market, they often have to make a significant commitment of capital for a relatively long period of time before their investment comes to fruition. Derivatives offer an alternative whereby an investor can guess at the price movement of some underlying security while paying only a fraction of the cost it would take to buy the security outright. Although it allows a little more flexibility than the traditional market, the derivative market is extremely volatile. As a result, investors usually should take precautions to protect themselves from potentially huge losses.
In general, the safest play in the derivative market is to be the buyer of a derivative contract. The buyer is in the "long" position on a contract, which, in a typical options contract, means that he only risks the premium paid for the contract. If the contract goes in the opposite direction from what the buyer anticipates, he still only loses the premium. On the other hand, if the price moves with the buyer's expectations, the profits can be extensive.
By contrast, the sellers in the "short" positions in the derivative market should generally take measures to protect themselves against those big losses. One way is to adjust the premium received for the contract so that it can offset the potential losses that the short position faces. Another way is to hedge against the loss by taking on a contrasting position on the asset underlying the contract, allowing the investor to benefit no matter which way the price moves.
Since options and futures contracts depend on speculated price movements, it is difficult to determine the value of contracts in the derivative market at the time they are bought. For that reason, options and futures pricing models are available which can help determine if a contract is worth its price. These models can also project the price of underlying assets for the duration of derivative contracts, which can help investors decide when to exercise the contracts and when to sell them at their peak values.
