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How Do I Choose the Best Derivative Instruments?

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  • Written By: Geri Terzo
  • Edited By: Shereen Skola
  • Last Modified Date: 21 November 2016
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Derivatives are financial securities that obtain a value based on the worth of another asset, including stocks or bonds. To choose the best derivative instruments, an investor can weigh the current market conditions and also attempt to anticipate the direction in which trading is poised to take. Two of the common derivatives that are used are options and futures. The ideal assets may depend on your time frame for investing, confidence in your conviction about the markets, and price.

Prior to deciding which derivative instruments to use, you may benefit from identifying the characteristics of both assets. These securities are often deemed more risky than traditional assets, including stocks and bonds. There is generally a degree of speculation that accompanies derivative investing.

Options are among the derivative instruments you may have to choose from. Selecting these securities gives you the choice to purchase or sell some asset at a future date in time for a pre-determined price. If you decide it is not worth your while to proceed with the transaction, you can allow the maturity date of the contract to expire without making a move. You are still likely to lose the upfront investment that you made to secure the options contract, however.

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A futures agreement is somewhat more stringent; similar to options, a futures contract designates a particular price for some asset at a later date in time. Instead of allowing the expiration date to pass by, however, you must determine if you would like to follow through with the delivery of the underlying asset in a futures contract. This could be agricultural items or raw materials, such as cotton or metals. In the event you are not interested in receiving delivery of these physical assets, you can settle a futures contract for cash. Farmers participate in this market to secure prices for agricultural crops.

In selecting the best derivative instruments, you should decide how much risk you can afford to take. There are some extremely speculative contracts that have the promise to deliver sizable returns but that would trigger significant losses if the trade goes bad. You also can uncover more conservative derivative instruments that may not generate the most profits but are less likely to cause insurmountable losses.

The average investor is likely to gain the most transparency from trading derivatives on some major exchange. The other choice is to buy and sell contracts in the over-the-counter markets, where there is less price assurance. Also, it may be wise to trade derivatives in regions where there is regulatory oversight of these securities because of the speculative nature that is inherent in these risky assets. Before selecting which derivative instruments to trade, you should evaluate the market conditions. If you believe that the cost for the underlying asset in a derivative contract will rise in the future, you may be able to lock-in a bargain price early, selling the assets for a profit later.

The best derivative instruments may be included in some investment portfolio, such as an exchange traded fund (ETF), overseen by a professional. If you feel confident about the market sentiment surrounding a particular asset class, such as stocks, you might select an options ETF that provides you with exposure to a particular group of equity securities. The expense ratio for ETFs is widely considered acceptable and you gain the trading expertise of some asset management firm. Also, you can trade an options ETF similar to the way you buy and sell individual securities so there is an element of convenience tied to this method.

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