The popularity of derivatives trading is progressing monumentally as their returns are considerably higher. Including derivatives in a trader’s portfolio will help him limit losses that might happen due to the volatility of the underlying assets. Nearly all investment portfolios can benefit from using derivatives to complement conventional assets or as the basis for a separate investment product, such as a hedge fund or guaranteed return fund.

However, as gainful as derivatives might appear, there are multiple risk factors behind those expensive smiles. If not appropriately managed, investors might risk their money or entire investments. This article will explore the potential risk factors of derivatives trading and techniques to mitigate them effectively. 

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Understanding Derivative Instruments

Derivative instruments, as the name suggests, are financial contracts whose value is acquired from an underlying asset, index, or rate. They play a significant role in handling financial risks, speculating asset prices, and hedging risks. A derivative is established between multiple parties that can trade on an exchange or over the counter. 

Derivatives were introduced in India in the 2000s, and since then, the market has evolved tremendously. As a multifaceted instrument, derivatives have reshaped the financial market by offering investors various risk management tools. Different types of derivatives can hedge a position, speculate on an underlying asset, or give leverage to holdings. The different types of derivatives include:

1. Futures

Futures are standardized agreements that can be traded on an exchange. They are a kind of derivative contract between two parties to purchase an underlying asset at a pre-agreed price on a future date.

2. Forwards

Forwards are similar to Futures. It is an agreement between two parties to trade an underlying asset at a pre-determined price on a future date. However, unlike Futures, they do not trade in exchange and only happen over the counter. 

3. Swaps

As the name suggests, swaps allow traders to exchange financial instruments with each other. Since Swaps can potentially switch from one kind of cash flow to another, it has been a very popular derivative. 

4. Options

In terms of definition, options are similar to futures. However, unlike Futures, the buyer does not have to buy or sell on the specified future date. It is just an option, not an obligation. 

Types of Risks in Derivatives Trading

Now that we have understood the basics of Derivatives and the different types of Derivatives in the market, let’s examine the risks associated with them. 

Market Risk

Market risk is the kind of risk associated with any investment. It depends on the decline in the value of a financial instrument or underlying asset. Market risks are closely connected to global market conditions. Traders choose their investments based on numerous factors that can potentially determine how an asset will perform in the future. 

Credit risk

Credit risk is the risk of loss when the counterparty defaults on its obligations. When this happens, the investor might not get the total value, incurring losses. However, in the case of exchange-traded derivatives, credit risks are zero as the clearing house acts as the counterparty. 

Liquidity Risk

Liquidity risk is another significant risk associated with derivatives trading. It is the risk of investors closing out a derivatives trade at a fair price before maturity. In this scenario, the gap between the bid and the offer will be considerably high, and there will be no fair price. 

Operational Risk

Operational risks are another major type of risk in derivatives trading. Such risks may result in losses due to human error, inadequate procedures, or system failures. Although such instances are rare, they can incur significant losses to investors if they do not exit the position in time. 

Regulatory risk

Regulatory risk is the potential for changes in laws and regulations, which can impact trading activities and financial outcomes. In extreme conditions, such changes might even destroy a company’s business model. 

Risk Management Strategies

Knowing all about the potential risks in derivatives trading is easy. However, what matters is learning the risk management strategies. Here are some practical risk management strategies to follow:

1. Hedging

Hedging is a strategy in which traders take an offsetting position in a related asset to reduce the price risk of an existing position. This strategy allows traders to minimize volatility risk during derivatives trading. 

Some hedging techniques are:

2. Diversification

Portfolio diversification is a risk management strategy in which you invest in a variety of assets to achieve higher returns with minimal risk. By including stocks, commodities, bonds, and other assets in the investment portfolio, traders can considerably lower the impact of poor performance of any one investment involved. 

Diversifying the portfolio to accommodate various asset classes, such as real estate, fixed income, equities, and commodities, can help investors mitigate the risks further. Buying index funds is another way to diversify the investment at a lower price. Such strategies would give the investors a buffer against market volatility. 

3. Use of Risk Metrics

RiskMetrics is a set of tools that enable investors to estimate their exposure to market risk under the “Value-at-Risk framework.” It is a measurement that estimates a portfolio’s maximum potential loss over a period of time. VaR gives investors an understanding of the risk of loss in their portfolios and helps them make informed decisions. 

Stress testing is another method for analyzing a portfolio’s risk. It is a computer simulation designed to understand how a portfolio would behave in extreme market conditions. 

4. Setting Limits

Investors can set limits to minimize losses. Investors can save their portfolios from major asset value declines by giving standing instructions to sell an asset when its price falls below a certain point. 

Position sizing involves allocating a certain capital amount to a specific investment based on risk tolerance and market conditions. Careful position sizing ensures that a single investment does not significantly impact the entire portfolio. 

5. Constant Monitoring and Review

Investors should periodically monitor and review their investment portfolios for effective risk management. Here are some ways to stay updated:

Techniques for Managing Market Risk

There are some proven techniques for mitigating and managing market risks in derivatives trading. Let’s examine some of them. 

Techniques for Managing Credit Risk

A robust credit risk management technique could prevent your portfolio from incurring significant losses. Here are some practical techniques for mitigating credit risks.

Techniques for Managing Liquidity Risk

Liquidity risk is the possibility of loss when a financial instrument cannot be traded within a specified time period. To mitigate such risks, the investor could integrate some practical strategies. 

Techniques for Managing Operational Risk

The constant changes in market conditions and increased trade volumes demand a robust risk management strategy. Here are some practical techniques to manage and mitigate operational risks in derivatives trading. 

Techniques for Managing Regulatory Risk

Managing regulatory risk is of prime importance in derivatives trading. Here are some proven techniques for managing risks effectively. 

Conclusion

Derivatives trading is as lucrative as it looks and sounds, but its risks may not always be easy to mitigate. Every trade comes with risks, and so does derivatives trading. However, by following the strategies mentioned above and techniques, investors can manage the risks and stay safe in the derivative market.