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Derivative Contracts
Derivative contracts are agreements by which a trader gains leverage on investments in underlying financial instruments such as stock shares. Derivative contracts derive their value from the underlying instrument. However, they offer the opportunity for greater profit, the option to buy stock or sell stock at a given price, the possibility of hedging risk, and the possibility of trading where there is no underlying financial instrument. Derivatives contracts include those used in trading options, futures, commodities, foreign exchange trading, interest rates, or credits.
2. Derivative contracts are agreements by
which a trader gains leverage on
investments in underlying financial
instruments such as stock shares.
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4. However, they offer the opportunity for
greater profit, the option to buy stock or
sell stock at a given price, the possibility
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5. of hedging risk, and the possibility of
trading where there is no underlying
financial instrument.
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6. Derivatives contracts include those used
in trading options, futures, commodities,
foreign exchange trading, interest rates,
or credits.
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7. Derivative contracts can be complex
(exotic) or they can be simple (vanilla).
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8. The underlying features that all have in
common is the ability to gain more profit
and to have more choices at a future
date.
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9. The risk with these contracts varies.
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10. For example, buying calls in options
trading gives the buyer the option to buy
100 shares of stock per contract on or
before a given date, the contract
expiration date.
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11. Traders will pay a premium for this
opportunity and will exercise options
contracts, the derivatives, if the stock
price goes up enough to make a profit.
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12. On the other hand selling calls gains the
trader a premium but gives away the
opportunity for substantial profits if the
stock price goes up dramatically.
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13. The risk involved in derivative contracts
varies.
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14. In fact, many trade derivatives as part of
a hedging strategy while others engage
in options trading and futures trading
with potentially unlimited risk.
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15. An example of trading derivatives to
reduce investment or business risk is a
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16. gold mining company selling futures on
gold at a price below the current market
value.
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17. The company guarantees themselves a
profit on part of their expected
production.
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18. This trading strategy can be used by
investors in the company as well.
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19. Those engaged in long term investing
can also take advantage of derivative
contracts.
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20. A common tactic is the use of covered
call options.
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21. An investor who is familiar with the
support and resistance zones of one of
his cyclical stocks can profit by selling
covered calls when the stock is at the
top of its traditional trading range.
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22. The investor gains the premium,
offsetting his portfolio loss, while the
stock cycles down in price.
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23. Another covered option is buying puts
on a stock that has recently run up in
price.
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24. The stock owner pays a little insurance
in the form of the premium.
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25. If the stock corrects substantially he or
she will then exercise the put options,
sell at the strike price, and buy again at
the new, lower, spot price.
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26. Managing risk in trading derivative
contracts is important.
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27. Selling uncovered call options or
uncovered put options opens the trader
to potentially huge risk if the underlying
financial instrument goes up
dramatically in price.
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28. This sort of trading in derivatives is
statistically very profitable.
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29. That is why large institutional traders do
it.
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30. The problem for the individual investor
or trader is that every so often the trade
goes bad and there is a price to pay.
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31. Large institutions can handle the cost.
Most individual investors cannot and
should typically avoid trading where the
potential for loss is great.
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32. Online Stock Market Reviews presented
live via the internet by Stephen Bigalow
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