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Examples of Derivatives and How they Work

Examples of Derivatives and How they Work

Derivatives give investors a powerful way to participate in the price action and underlying security. Those who invest in derivatives look to transfer specific risks associated Financial Brokerage Company with the underlying asset to another party.

In this article, we will take a look at some of the most popular derivatives that many investors and traders use to gain specific benefits. Check them out and see how they can enhance your annual returns.

Options

Options enable investors to hedge risk or to speculate by taking on extra risks. Buying a call or put option contract gives the rights but the obligations to buy (call) or to sell (put) shares or futures contracts at a predetermined price or on an expiration date.

They are traded on Exchanges Online Stock Brokers and centrally cleared and that provides liquidity and transparency, which are two critical factors to consider when taking exposure to derivatives.

There are three primary factors you have to consider to determine the value of an option: the time premium, intrinsic value, and volatility.

 The time premium decays as the option nears expiration while intrinsic value varies with the price of the underlying asset. Volatility is ever-present on the stock or contract.

Single Stock Futures

A single stock future (SSF) is contract to deliver 100 shares of a certain stock on a predetermined expiration date. The SSF market price is based on the price of the underlying asset as well as the carrying cost of interest, minus dividends paid over the term of the contract.

Trading SSFs requires lower margin than merely buying or selling the underlying asset. It often fall under 20 percent range, providing investors and traders more leverage. SSFs are also not subject to SEC day trading regulations or to the short seller’s uptick rule.

A SSF usually track the price of the underlying asset. That means you can apply common investing strategies. Check out these common SSF applications:

  • Cheap way to buy a stock
  • Cost-efficient way to hedge for open equity positions
  • Protection for a long term position against volatility or short term declines in the price of the underlying asset
  • Long and short pairs that offer exposure to an exploitable market
  • Exposure to specific economic sectors

Warrants

A stock warrant provides the holder the right to buy a stock at a certain price at a predetermined date. Just like call options, you can exercise stock warrants at a fixed price. When issued, the warrant’s price is always higher than the underlying stock. However, it carries a long term exercise period before expiring.

When you exercise a stock warrant, the company issues new common shares to cover the transaction, unlike call options where the call writer must provide the shares if the buyer exercises the option.

Contract for Difference

A contract for difference, or CFD, is a deal between a buyer and a seller than requires the seller to pay the buyer the spread between the current stock price and value at the time of the contract if that value rises. Conversely, the buyer has to pay the seller if the spread is negative.

The CFD’s goal is to permit investors to speculate on price movement without having to actually own the underlying shares. CFDs are not available in the United States but provide a popular alternative in countries like Canada, France, Germany, Japan, the Netherlands, Singapore, South Africa, Switzerland, and the United Kingdom.

 

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