Understanding risks while trading in derivatives

Derivatives are financial instruments that derive their value from an underlying asset, such as a stock or a commodity (see the article Understanding Derivatives). They are often used to manage risk or speculate on the future price movements of the underlying asset. While derivatives can be a useful risk-management tool for investors, they also carry significant risks.

The risks
Primarily, there are five major risks

Market risk refers to the risk of a decline in the value of the underlying asset. This can happen if there is a sudden change in market conditions, such as a global financial crisis or a natural disaster. If the value of the underlying asset falls significantly, the value of the derivative can also decline, potentially leading to significant losses for investors.

Leverage can enhance the impact of market risk. Since an investor is required to pay only the margin or premium, as the case may be, the actual exposure to the underlying would be a multiple of the amount paid. If the investor has not properly understood and put a significant amount of capital towards the margin or premium, the losses could be huge, potentially wiping the investor out financially.

Another risk associated with derivatives is credit risk—the risk that the counterparty to the derivative contract will default on their obligations. If a counterparty defaults on a derivative contract, the investor may not receive the full value of the contract, leading to losses. However, this risk does not exist in the case of exchange-traded derivatives, as the clearing house or clearing corporation acts as the counterparty.

Liquidity risk is another significant one. It refers to the risk that an investor may not be able to exit a position in the derivative market quickly or at a fair price. In the Indian securities markets, most actively traded derivatives contracts are short-term, so liquidity risk may not be much as the contract will expire soon.

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes, people, or systems, or from external events. While such instances could be rare, these incidents can lead to significant losses for investors who are unable to exit their positions in time.
In conclusion, derivatives can be a useful tool for investors in the Indian securities markets, but they also carry significant risks. Investors should be aware of the risks associated with derivatives and take steps to mitigate these risks. These measures can help investors use derivatives to manage risks better and potentially enhance their returns.