Here are the Risks involved in Trading Derivatives

Derivatives are investment instruments that consist of a contract between parties whose value derives from and depends on the value of an underlying financial asset. However, like any investment instrument, there are varying levels of risk associated with derivatives.This article will cover derivatives risk at a glance, going through the primary risks associated with derivatives: market risk, counterparty risk, liquidity risk, and interconnection risk
Market Risk
Market risk refers to the general risk of any investment. Investors make decisions and take positions based on assumptions, technical analysis, or other factors that lead them to certain conclusions about how an investment is likely to perform.
Counterparty Risk
Counterparty risk, or counterparty credit risk, arises if one of the parties involved in a derivatives trade, such as the buyer, seller or dealer, defaults on the contract. This risk is higher in over-the-counter, or OTC, markets, which are much less regulated than ordinary trading exchanges.
Liquidity Risk
Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Overall, liquidity risk refers to the ability of a company to pay off debts without big losses to its business.
Interconnection Risk
Interconnection risk refers to how the interconnections between various derivative instruments and dealers might affect an investor’s particular derivative trade.

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Trading in derivatives involves the following risks:

Market Risk
Market risk, in simpler terms, is the risk that investment is exposed to due to changes in the economy or the market where the investment has been made. When you take a position on a stock, you analyze the market to reach a conclusion and position yourself accordingly. However, sudden changes in the market can cause losses.

Counterparty credit risk
In a derivatives contract, there is a buyer, seller, and dealer. If any of these parties defaults, then others can suffer losses. This is the counterparty risk.

Liquidity Risk
In the derivatives market, liquidity risk pertains to investors who can close a derivative before its maturity. It also refers to the ability of a company to clear debts without suffering losses.

Interconnection Risk
This is the risk due to interconnection between derivative instruments and/or dealers. For example, if a bank is a dealer in a derivative trade, then any problem with the bank can impact all trades where it is the dealer and snowball into bigger problems for the market.

If you plan to start trading in derivatives, ensure that you open a trading account with a platform like Motilal Oswal that offers a robust and secure platform for trading with recommendations and competitive prices.