FAQS
What are the 4 types of derivatives?
The main types of derivatives are:
- Futures – Standardized contracts to buy/sell an asset at a future date.
- Options – Give the right (but not obligation) to buy/sell at a set price.
- Swaps – Agreements to exchange cash flows (e.g., interest rate swaps).
- Forwards – Customized contracts similar to futures but traded over-the-counter (OTC).
What are the basics of derivatives?
🔹 A derivative is a financial contract that derives its value from an underlying asset (stocks, bonds, commodities, currencies, interest rates).
🔹 Used for hedging risk or speculating on price movements.
🔹 Traded on exchanges (e.g., CME, ICE) or OTC (customized private deals).
Is derivative trading difficult?
✅ Yes, for beginners, because:
- Prices are affected by multiple factors (market trends, interest rates, time decay).
- High leverage = High risk & reward.
- Requires deep market knowledge.
❗ With practice and strategy, it can be profitable but carries significant risk.
What are the limitations of derivatives?
❌ High risk – Losses can exceed initial investments.
❌ Complexity – Requires market expertise.
❌ Liquidity risk – Some contracts may be hard to trade.
❌ Leverage risk – Small price movements can cause big losses.
What is the biggest underlying issue with derivatives?
The biggest issue is counterparty risk – the risk that the other party may default.
- OTC derivatives have higher risk because they lack a central clearing house.
- During the 2008 financial crisis, unregulated derivatives (like credit default swaps) contributed to the crash.
Can a derivative exist without a limit?
❌ No. Every derivative has a predefined contract limit, either:
- Expiry date (for futures, options).
- Notional value (for swaps, forwards).
Unlimited risk exists only in naked short options (where losses can be infinite).
What are the 7 rules of derivatives?
The 7 key principles when trading derivatives:
- Know your risk exposure – Understand the worst-case scenario.
- Use leverage wisely – Avoid overexposure.
- Understand pricing factors – Interest rates, volatility, time decay.
- Set exit strategies – Predefine stop-loss and take-profit levels.
- Follow market trends – Stay updated on economic indicators.
- Manage liquidity risk – Avoid illiquid contracts.
- Regulatory compliance – Follow trading rules and exchange requirements.
How do derivatives manage risk?
🔹 Hedging: Protects against price movements (e.g., airlines use oil futures to avoid fuel price volatility).
🔹 Diversification: Reduces overall portfolio risk by using contracts linked to different assets.
What are the two main uses of derivatives?
- Hedging – Protecting against market fluctuations.
- Speculation – Profiting from price movements.
What are 4 main features of a derivative?
- Underlying Asset – Derives value from stocks, commodities, currencies, etc.
- Leverage – Small investments control large positions.
- Expiry/Settlement Date – Contract validity period.
- Risk & Return Relationship – High potential for profit or loss.