The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. 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. Among the most common derivatives traded are futures, options, contracts for difference, or CFDs, and swaps.
Market risk refers to the general risk in 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. An important part of investment analysis is determining the probability of an investment being profitable and assessing the risk/reward ratio of potential losses against potential gains.
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. A regular trading exchange helps facilitate contract performance by requiring margin deposits that are adjusted daily through the mark-to-market process. The mark-to-market process makes pricing derivatives more likely to accurately reflect current value. Traders can manage counterparty risk by only using dealers they know and consider trustworthy.
Liquidity risk applies to investors who plan to close out a derivative trade prior to maturity. Such investors need to consider if it is difficult to close out the trade or if existing bid-ask spreads are so large as to represent a significant cost.
Interconnection risk refers to how the interconnections between various derivative instruments and dealers might affect an investor's particular derivative trade. Some analysts express concern over the possibility that problems with just one party in the derivatives market, such as a major bank that acts as a dealer, might lead to a chain reaction or snowball effect that threatens the stability of financial markets overall.