Understand risk in derivatives markets
Many investors use derivatives to help manage risks associated with changing market conditions. This is often referred to as hedging.
While market prices, interest rates and other factors can fluctuate over time, derivatives can be used as part of a broader investment strategy to help manage exposure to these movements.
While derivatives can be used to express a market view or gain exposure to a particular asset class, they can also be used to help manage risk associated with changing market conditions. Before using derivatives, it is important to understand how these products work, the risks involved and whether they are suitable for your investment objectives.
Why do investors manage risk?
Markets can move for many reasons, including:
- Changes in interest rates
- Inflation expectations
- Economic data releases
- Political and geopolitical events
- Changes in market sentiment
Understanding how these factors affect investments is an important part of managing risk.
How can derivatives be used?
- Derivatives can be used to:
- Help manage exposure to market movements
- Protect against specific risks
- Express a market view while managing portfolio exposure
- Gain exposure to a market without directly purchasing the underlying asset
Understanding key risks
Before using derivatives, investors should understand:
Margin |
Many derivatives require an initial margin deposit. |
Volatility |
Market prices can move quickly, increasing both opportunities and risks. |
Liquidity |
Liquidity can affect the ease of entering or exiting a position. |
Contract expiry |
Derivatives contracts typically have expiry dates and settlement procedures that investors should understand. |
Key concepts to understand
Margin |
Many futures contracts require an initial margin, which is a percentage of the total contract value. Investors should understand that gains and losses are based on the full value of the contract. |
Volatility |
Market conditions can change quickly, resulting in larger price movements and increased risk. Higher volatility can result in larger price movements, increasing both potential gains and potential losses. |
Liquidity |
Liquidity refers to how easily a position can be opened or closed in the market and can affect trading flexibility. |
Expiry and settlement |
Futures contracts have defined expiry dates and settlement processes. Investors should understand when contracts expire and how settlement works before entering a position. |
Responsible investing starts with education
Before trading derivatives, investors should take the time to:
- Understand how the product works
- Learn about the underlying market
- Assess their risk tolerance
- Understand margin requirements
- Familiarise themselves with contract specifications
- Consider whether the product is suitable for their investment objectives
A strong understanding of risk is an important part of becoming a more informed investor.
Learn more about the common misconceptions with derivatives.