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Step by step guide on how to invest in derivatives

Derivatives. That single word made many young students drop maths as a subject in favour of a totally different educational path. Luckily, derivatives are not limited to the world of mathematics alone. There is a whole financial market that involves trading in derivatives. Remember, this has nothing to do with maths (well, not much anyway).
A derivative is a financial contract that derives its value from an underlying asset. This could be stocks, commodities, exchange rates or currencies. Through derivative trading, you can take a measured bet on the future value of an underlying asset. Here are a few steps to guide you in your journey in derivatives.

1) Understand how derivatives work
It is often said that knowledge is power. To add to it, knowledge is money too. Trading in derivatives offers great potential for investors to make money. But this is possible only if you are equipped with sound knowledge of how the market functions. Also, be updated with market events. For example, if you are interested in futures trading in the commodities segment, you should keep track of how the prices of metals, oil and other commodities are changing in India and international markets.

2) Find a broker
You can trade in futures and options through most online brokerages in the market. If you are already trading in stocks, you can get started on your derivatives trading at the same place. If you are a beginner, you need to find a good brokerage firm and open a trading account. Select a broker who offers dedicated support and competitive commission rates.

3) Identify where you wish to trade
Alright, you want to trade in derivatives. But which category are you interested in? There is a huge market open right in front of you. Agriculture, crude oil and metals are some of the categories available in commodities alone. You can also trade in the stock market, forex market and indices. Identify which category interests you to begin trading.

4) Create a trading plan
Once you identify a category, you need to do some research to get a better idea about the market. If you already have knowledge about a particular sector, you can start there. For example, if you work in the mining industry, derivative trading in the metals sector is a good idea. After this, you need to create a trading plan to guide you along on your investment journey. Make a list of contracts, time periods and investment goals in a journal. It is quite common for investors to make investment decisions based on emotions once their money is on the line. Instead, what you need is rational thinking. And for this, a trading plan is important.

5) Set up stop loss and profit targets
When trading in derivatives, it is always recommended to create a stop loss and profit target. The market can be unpredictable. For example, stock prices may be rising for a certain period of time but all of a sudden, the prices could drop without warning due to some macroeconomic effect. That’s why, even when you are doing well in the market, it is better to create a profit target and exit when you reach the target. Similarly, when the market moves in the opposite direction, good traders identify when to exit the trade and accept losses. By staying in the trade and waiting, you only risk losing a larger sum of money as time passes.

6) Keep track of your position
Your work does not end once you enter into a futures or options contract. You need to keep track of your positions. A single derivatives trade can go on over a period of months. For instance, you may enter a call option to buy a stock at a particular price (say, Rs 50) in the next six months. To go through with the trade, the stock price should be lower or equal to what you expected. If the stock price goes beyond Rs 50, you don’t need to complete the trade. And for that, you need to be aware of how the stock moves regularly. Keep a record of market movements and adjust your positions in a suitable manner.

To sum up
Investing in derivatives is not very hard. Anyone can trade in derivatives but to consistently earn good returns is a different matter altogether. You need to know your risk appetite and investment goals and invest accordingly. These steps can help you begin your journey into derivatives. Over time, you can gain more experience and identify your own investment system.


Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.