How to make a living from derivative market trading: A comprehensive guide

Since its introduction in 2000, the derivatives market in India has become increasingly prominent among traders both domestically and internationally. 

Similar to shares, derivatives are traded on stock exchanges, and their popularity is evident through the significant daily turnover they generate. Unlike traditional stock trading, derivatives offer unique opportunities for profit through contracts based on underlying assets’ values. 

However, understanding the safety of derivative market trading is crucial for those considering it as a means of livelihood. But among this popularity, a pressing question arises: is derivative market trading safe?

In this article, we’ll delve into the safety aspects of derivative trading and explore whether it’s a reliable avenue for making a living.

Understanding derivatives

The term “derivatives” in finance refers to financial contracts whose value is derived from the performance of an underlying asset, index, or entity. Everything from stocks and bonds to currencies and commodities to interest rates and more may be considered underlying assets.

With derivatives, investors can speculate on how much an asset’s value will rise or fall without actually purchasing the underlying item. They provide opportunities for hedging against risk, such as price fluctuations, and also enable traders to leverage their positions for potentially higher returns.

The 4 Common types of derivatives include:

• Options
• Futures
• Forwards
• Swaps

Each of these derivatives serves different purposes and caters to various risk management and trading strategies. The term “derivatives” thus reflects the financial instruments’ dependency on and derivation from an underlying asset or factor.

Before we find the answer to the question, Is derivative market trading safe? We have to discuss its pros and cons to understand it better.

Pros of derivative market trading

Here are some advantages offered by derivatives trading:

1. Arbitrage opportunities

Arbitrage in derivative trading means profiting from price differences between related assets. For instance, if the price of an asset in the derivative market is lower than its actual value in the underlying market, you can buy it in the derivative market and sell it in the underlying market, pocketing the difference as profit. 

This practice helps to stabilise prices and ensures efficiency across markets while offering opportunities for traders to earn profits.

2. Price discovery

Derivative markets help determine future asset prices, aiding decision-making. For instance, if futures contracts for a commodity show increasing prices, it suggests anticipated demand, influencing decisions like production levels. 

Similarly, options pricing reflects market expectations, guiding traders on potential asset movements. This insight assists businesses and traders in planning, strategising, and managing risks effectively.

3. Leverage

Leverage in derivative trading means you can control significant trading with a small amount of money. For instance, with just a fraction of the total value, you can enter into a contract that represents a much larger position. This amplifies potential gains if the trade goes well. 

However, it’s crucial to understand that while leverage can magnify profits, it also increases the risk of losses, so caution is advised.

4. Risk management

Derivatives help you reduce the risk of losing money on other trades. For instance, if you own stocks and worry about a market downturn, you can use options contracts in the derivatives market to protect your stock trades. 

This means that even if the stock prices fall, you won’t lose as much because the options will compensate for some of the losses. It is similar to having trade insurance.

5. Diversification

In derivative market trading, you can easily access a variety of assets like stocks, bonds, commodities, and currencies without directly owning them. 

This diversification helps reduce the risk of losing all your trades if one asset performs poorly. It’s like not putting all your eggs in one basket, ensuring your trades are spread out for better risk management.

6. Market efficiency

Derivative markets are efficient because they have high liquidity and speedy transaction execution. This means you can buy or sell contracts quickly at fair market prices without significant delays or price distortions. 

The efficiency stems from the constant activity and competition among traders, ensuring that prices reflect all available information. 

Consequently, you can confidently enter and exit trades without worrying about facing unfavourable prices, making derivative trading a smooth and reliable process.

Cons of derivative market trading

Besides the benefits, trading in the derivatives market has its downsides. Here are some drawbacks to consider:

1. High risk

Trading derivatives can be risky due to leverage. This allows you to manage a bigger position with less capital. 

While this can lead to big gains, it also means you could lose more than you initially put in if the market moves against you. It’s like borrowing money to trade, so if things don’t go well, you might owe more than you have.

2. Complexity

Derivative trading can be hard to understand because it involves complex financial products. Without sufficient knowledge, mistakes are common. 

Understanding how these products work and how they’re affected by market changes is crucial. If you don’t grasp the complexities, you might misinterpret trends or make risky decisions. 

It’s essential to educate yourself thoroughly before getting involved in derivative trading to minimise potential losses and maximise your chances of success.

3. Counterparty risk

Counterparty risk in derivative trading refers to the possibility that the other party involved in a contract may fail to meet their obligations. 

For example, if you enter into a derivative contract and the counterparty defaults, you may not receive the agreed-upon payments or may incur losses. 

This risk is heightened in over-the-counter (OTC) markets where contracts are privately negotiated, increasing the importance of assessing the creditworthiness of counterparties before engaging in transactions.

4. Liquidity risk

There might not be enough buyers or sellers when you want to make a trade, especially during market stress. This can make it hard to buy or sell at desired prices, leading to slippage or even not being able to exit positions. 

Essentially, it’s like trying to sell something when there aren’t many people interested, which can affect your ability to trade smoothly.

5. Limited transparency

Unlike traditional stock markets, where prices are transparent, derivative markets can be opaque, making it hard to gauge actual market conditions. This lack of transparency can impede informed decision-making, potentially leading to suboptimal trades. 

Traders may struggle to accurately assess risks and opportunities due to limited visibility into pricing dynamics and trading activity.

Is the derivative market safe to make a living?

Derivatives trading can be a way to earn a living if done correctly. Here are some ways to earn money from derivatives trading:

• Use existing assets: You can use your current assets as margins and earn an income without making any further commitments.
• Options income funds: An option income fund is also known as an option income closed-end fund (CEF). It is a type of pooled investment whose goal is to generate current income for its traders by earning premiums from selling options contracts. 

According to the studies, you can limit your losses to 1% and take your gains to 1.5% or above by sticking to a 1% risk strategy, setting strict stop-loss orders, and establishing profit-taking levels.

However, it’s crucial to note that derivatives trading carries significant risks, including the possibility of losing more than your initial trade. 

Therefore, you should educate yourself thoroughly, use risk management strategies, and potentially seek advice from financial professionals before engaging in derivatives trading.

Conclusion

Trading in the derivative market for livelihood requires careful consideration of its risks and rewards. While it offers the potential for high returns, it also poses significant risks due to volatility and leverage. 

However, with proper knowledge, experience, and risk management strategies, you can mitigate these risks and strive for success. To learn more about derivative trading, explore StockGro.

FAQs