Derivative Trading: What Is It, And How Does It Work?

If you were to read the Collins English Dictionary, it would say a derivative is an investment that depends on the value of something else. They are the modern-day representation of traditional practices wherein individuals used to place bets with one another, or farmers would agree to sell their crops in advance as insurance. A derivative is a contract between two or more parties based on an underlying financial asset.

In derivative trading, traders speculate on the future price movements of an underlying asset without having to purchase the asset itself in the hope of booking a profit. To keep it simple, they bet whether a share price will rise or fall in the future.

In the financial markets, traders also use derivatives to mitigate the risk of financial assets. The underlying assets that form the basis of derivative trading include:

Invest with as low as $1000

High liquidity

Virtually zero risk

Highest yield in 15 years

Invest with as low as $1000

High liquidity

Virtually zero risk

What are corporate actions?

In the business world, for better or worse, a company’s future is determined by its corporate actions. And a better understanding of how the corporate action life cycle works will help give an idea of how a company conducts its business and manages its financial health.

Corporate actions are initiatives taken by the Board of Directors of a company with the approval of shareholders. The decisions made can have a substantial impact on a company and its stock price. It could be something like rebranding and changing a company’s name to deciding to declare dividends. Other examples of corporate actions include mergers and acquisitions, share buybacks, and stock splits.

Corporate actions can be broadly categorized into two types based on their impact - monetary and non-monetary. It means that some corporate actions have a financial impact while others don’t.

So, let us look at the type of corporate actions that influences online trading activity and how:

Dividends

A corporate action can include a company that pays out dividends. This is basically where a company pays shareholders a portion of its profits or reserves as a form of income. In most cases, dividends are paid per share basis or a percentage of the share’s face value.

Bonus Issue

Another way companies take corporate action is through the issue of bonus shares where additional shares are issued to shareholders. A common example is a 1:1 bonus issue, where investors get an additional share for every share they own. But how is the market capitalization of a company affected when a bonus issue is made?

While bonus issues increase the number of shares held by investors, they also decrease the market price of each share. As a result, the market capitalization of the company remains the same. The allotment of bonus shares is done in accordance with each shareholder’s stake. Thus, bonus shares are issued in a constant ratio, thereby leaving the relative equity of each shareholder undiluted.

Stock Split

Well, just like the name suggests, a stock split occurs when a stock is split into two or more portions. Working on the same principle as a bonus issue, here, the number of shares increase, but the value of the investment remains the same.

There are several reasons for companies to initiate corporate actions such as enhancing participation of retail investors, influencing share price and liquidity, returning profits to shareholders, and corporate restructuring.

Rights Issue

When a company initiates a rights issue, it essentially encourages existing shareholders to purchase additional shares in the company, typically at a discount to the market price. Companies usually use the proceeds from a rights issue to finance an expansion project, acquire new assets, or reduce debt. So, if investors are offered these rights issues, they need to do their research and be confident about that company’s future.

Buyback of Shares

When a company decides to repurchase its shares, it is generally a positive sign as the company seems confident about what it is doing and its future. This facilitates the return of profits to shareholders in a more tax-efficient manner than paying dividends.

Other reasons for buying back shares include:

Preventing another company from taking over

Preventing the share price from dropping further

Building confidence

Ownership consolidation

Lowering cost of capital

Improving key financial ratios

A sudden rise or fall in the price of a stock can be the result of corporate actions, and that is why understanding them, and their impact is important.