The Derivative World of Trading

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     Since the day the market has started, lots of institutional investors makes predictions and does arbitrage to ensure the institution they work on gain more than what they lost. It isn’t uncommon that some of these investors does predict how things will fold before it happened, and it isn’t uncommon as well that their predictions are accurate. Now, I'm going to talk about the types of derivatives trading and the types of market participants. There are 3 types of derivatives trading: hedging, forecasting, and arbitrage trading. Market participants participating in each type of trading are called hedgers, forecasters, and arbitrage traders.

To help you understand, we will explain the futures trading among derivatives.

Futures trading refers to entering into a contract to purchase goods needed at a specific time in the future at a price at present time, rather than directly purchasing the items currently needed. Now let’s talk about hedge trading. A hedging transaction is a transaction that takes the form (position) of a futures contract as opposed to the spot. A person who currently owns a commodity (spot) has a risk that the price of that commodity will decrease in the future. Therefore to hedge future risk, it is a contract to sell at a predetermined price present time. For example, a company whose payment is in dollars to a foreign country exports will manage the risk of exchange rate fluctuations through a contract (sell hedging) to sell the dollars that will be received in the future in preparation for a decrease in the value of the dollar at the time of future settlement.

Second, prediction trading is a trading activity that seeks to make a profit by buying and selling futures while taking the risk of price fluctuations in the futures market. In other words, it is a method of investing by predicting the direction of the market. If you expect the price to rise, you buy futures. And if you expect the price to fall, you sell futures.

Finally, arbitrage trading is a type of trading in opposite directions at the same to make a profit when there is a temporary discrepancy between spot and futures prices.

If the futures price is temporarily too high, it is common to sell the futures and buy at a relatively low price. You then make a profit by buying the futures again and selling the spot. Such arbitrage trading is beneficial to arbitrage traders and has a positive function in reducing the gap between spot and futures prices.

From what I explained above, we looked at the type of derivatives trading as an example of futures trading. However, this is a classification for convenience and is not pre-determined by the trader. However, in the derivatives market, hedgers are people who already own or will hold the spot, such as producers and manufacturers, and there are many institutional investors with better information than general investors for forecasting and arbitrage traders.