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May 25, 2010
Trading Derivatives
Trading derivatives instead of the underlying equity provides a range of benefits and entails a number of cautions. Derivative contracts can be used to gain leverage, engage in hedging or risk reduction, speculate, trade markets where there is, in fact, no underlying equity, to provide options for purchase or sale in uncertain market situations, and to profit from providing a kind of insurance for other traders. Options training with Stephen Bigelow will provide excellent insight into options trading and trading of other derivatives for the beginner. Traders engage in both fundamental and technical analysis of the underlying in order to profit in trading derivatives. Trading in options contracts, futures contracts, forwards, credit derivatives, foreign exchange derivates, and, the largest market, interest rate derivatives, can be done to reduce investment risk. However, the extensive leverage involved in some derivative trading can result in huge trading losses leading to such disasters as the $1.3 Billion in trading losses that bankrupted Barings Bank in 1995.

Derivatives are financial instruments whose value is based on the value, usually the anticipated future value, of underlying stocks, commodities, futures, or things like the weather or energy credits. Derivatives can be reasonably simple and they can be very complicated. Derivative markets are set up to help mitigate risk in trading but in doing so they provide the opportunity for the speculator to make money on market fluctuations. Using fundamental analysis of the underlying equity as well as technical analysis of market movement traders can profit handsomely.

The largest market for trading derivatives is interest rate derivatives. An interest rate derivative is the right to receive a given amount of money at a given interest rate. In mid 2009 there were $437 trillion in over the counter interest rate contracts and $342 trillion in interest rate swaps. Primarily this market is used by large companies to control their cash flows. Just as the small trader uses technical analysis to anticipate market prices large companies use technical analysis indicators to anticipate interest rate changes.

Trading derivatives also occurs in the Forex market. However, derivative trading is not buying and selling in a given currency pair but, rather, the use of Foreign exchange options, Forex swaps, currency futures, currency swaps, foreign exchange hedges, and binary options.

The first and primary use of trading derivatives is hedging business risk. For example, a gold mining operation will sell gold futures, promising to deliver a given quantity of refined gold a year hence at an agreed upon price. In this way the company mitigates the risk of a market reversal in the price of gold. Likewise agricultural producers will sell corn futures, soybean futures, engage in live cattle commodity trading and the like to obtain a guaranteed price on all or part of their anticipated production. Buyers of a commodity will, likewise, purchase options futures contracts in order to guarantee the cost of a product.

In trading derivatives the trader can use time honored tools such as Candlestick chart analysis to identify Candlestick pattern formations which will in turn predict changes in derivative prices.

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