What is the Difference Between Shares and Derivatives?

by Vinaya HS on September 8, 2017

in Finance

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Most investors are well-versed about shares but often have little understanding of derivatives. The latter is a high-risk high-reward investment option for those willing to assume more risk. Derivatives are based on an underlying asset or on the performance of companies and are traded differently from share trading.

Share and derivative trading have distinct benefits and it is important you understand the different products before making your decision. Both these options are well-situated for certain instances and comparing the two products will help you to build your overall portfolio.

Understanding derivatives

Derivatives are traded financial products that are based on certain underlying assets. These offer you the right or an obligation to buy or sell the underlying asset in the future at a pre-determined price. Therefore, the price fluctuations of the underlying asset have a significant impact on derivatives and so they are more volatile.
Difference between shares and derivatives

1. Leverage

Leverage is a mechanism that allows you to bank the profits made on the transactions. Derivatives have leverage built within the transaction and allow you to trade without actually blocking the entire capital needed for the trade. For example, if you buy a derivative for INR 1000, the value of the underlying may be INR 10,000. Therefore, when the price of the underlying asset increases by 1%, the actual profit on the derivative trade is 10% of the transaction. This allows you to earn higher profits in a shorter period of time; however, this leverage comes at a higher risk.

2. Risk

The risks associated with derivative trading are directly proportional to the potential rewards. You may be able to earn huge returns on your investment within a short period of time. However, there is also a higher risk of losing your capital investment. Stock market trading is more transparent and the risks are confined only to those shares where you assume an exposure. Therefore, it is recommended you trade in derivatives only if you have the appetite for high-risk.

3. Yield

Shares are able to deliver returns without any variations in its selling price. For example, you may earn rental income on a property in addition to the capital appreciation. Similarly, shares allow you to earn dividend income irrespective of the increase and decrease in its trading price. In comparison, derivatives have only the resale or execution value and may become completely worthless in case the underlying asset moves in an opposite direction.

4. Volatility

Both shares and derivatives are volatile; however, the latter more in comparison to the former. Higher volatility means heavier price movements to provide more profits. But it also means there is a possibility to make greater losses. On the other hand, the volatility in shares is much lesser than derivatives.

Derivatives and shares are good instruments to include in your investment portfolio. Therefore, understanding the pros and cons of both products is important to make your decision.

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