What Is Derivative Trading. Derivatives trading are financial instruments that derive their value from the value of the underlying asset. They are contracts to buy or sell underlying stock, commodities (such as gold or corn), currencies, or other assets at a specific price on a specific date.
Investors often use derivatives to hedge their risk, maximize their profits, or limit losses. Although they are available directly in the form of options or futures, the average investor can also access derivatives through the funds invested in them. However, this can be a risky investment and is not suitable for everyone. Take the time to understand what it is, how to use it, and the risks involved before trading derivatives.
What is Derivative Trading?
The derivatives market is one part of the financial market which also includes the stock market, bond market, and commodity market. The derivatives market is where traders buy and sell different types of derivatives, such as options, futures, forwards and swaps.
Options and futures are traded on regulated exchanges including the CME Group, the New York Stock Exchange (NYSE), and the Nasdaq. Forwards and swaps are privately negotiated, not traded on an exchange, and not available to the average investor. Futures contracts are also unregulated like options, futures, and swaps.
Options, futures, and swaps are regulated by the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
Types of Derivatives
There are two basic types of derivatives:
- Contracts with an obligation to buy or sell an asset at a specified time and price
- Contracts with the right to buy or sell, but not obligations
Futures and swaps are liability contracts. Options are rights contracts, and can have stocks, bonds, and futures contracts as the underlying asset.
contracts give you the right to buy or sell the underlying security — stocks, bonds, commodities, or even futures contracts.
Options are quoted at the contract price (premium), expiration date, and the asset price (the strike price). Options contracts are mainly of two types, calls or puts, and investors can use different options strategies to make successful trades.
Investors profit from calls when the price of the underlying or future stock rises above the strike price plus a premium for the contract. The investor makes a profit on the put when the price of the underlying asset falls below the strike price plus the premium.
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contracts have standard terms. They specify the product, quantity, quality, price, location, and delivery date. Products can be physical, such as corn, or financial, such as dollars or bonds. Contract prices are quoted on each exchange and are continuously updated.
Futures can also be used to buy and sell the price of a financial index, such as the S&P 500. Index futures contracts specify the index used, quantity, price, and settlement date. Since the index price is not a physical asset, there are only cash transactions on settlement — no product delivery. If the index price is higher than the contract price at settlement, the buyer makes a profit. If the index is lower than the contract price, the seller makes a profit.
Futures contracts have value, and options are traded for the right to buy or sell them.
Some businesses and traders may have special needs to protect prices that are not available in standard futures contracts. A forward is a special futures contract that is negotiated between a buyer and a seller. They do not trade on exchanges and are not regulated. For this reason, they have a higher risk of default, making them unsuitable for the average investor.
Swaps facilitate the exchange of securities, either with different maturities or with different cash flows. Common types of swaps include commodity swaps, currency swaps, credit default swaps, and interest rate swaps.
An example of a swap is one of a US company that borrows money and pays interest on that money in dollars, but sells its product in France and is paid in euros. If the Euro decreases in dollar value, the company loses money. A US company might look for a French company that borrows in euros and is paid in dollars. They can agree to exchange a certain amount of dollars and Euros at an agreed exchange rate for a certain period of time.
How Does Derivative Trading Work?
There are always buyers and sellers in every derivative transaction. The buyer of the derivative contract holds the long position while the seller of the derivative contract holds the short position.
Investors generally use the derivatives market for two purposes: hedging and speculation
Hedging is a risk management strategy to offset short-term price fluctuations, or volatility. Portfolio managers and traders can purchase call options to protect their shorted stocks from rising prices. Hedge fund managers often use derivatives extensively to increase returns and manage risk. Producers can purchase futures contracts to manage fluctuations in the price of the materials or currencies they need to make purchases in foreign markets. Farmers can use futures contracts to guarantee the selling price of their crops.
Speculators, like day traders, trading firms, and arbitrage, seeking profit from short-term price changes, up or down. Speculators use the derivatives market because it is a source of leverage that uses margin.
Options and futures contracts increase profits because they give investors control over a large number of stocks or commodities without having to buy or sell them until later.
What Do Derivatives Mean to Ordinary Investors?
Derivatives are complex and risky investments that may not be suitable for all investors.
Leveraged exchange-traded funds (ETFs), reverse ETFs, and managed futures contracts are ways for the average investor to take advantage of a broad portfolio of professionally managed derivatives using small amounts of money.
Leveraged and inverse ETFs are available to track a wide variety of financial indices and commodities. Leveraged ETFs use derivatives to increase the positive returns of an index. The 2x leverage ETF is built to generate double the returns of the index, positive and negative. Inverse ETFs make a profit when the index price drops.
Managed futures are a portfolio of futures contracts across a broad spectrum of commodities, currencies and financial indices. The average investor can use a managed mutual fund or ETF to diversify his portfolio and manage risk.
Pros and Cons of Trading Derivatives
- Manage risk
- Allows for speculation
- Very risky
- Complex and not always transparent
For the average investor, derivatives offer a way to diversify his portfolio and manage risk. Managed futures are a way to invest in assets that are not correlated, or up and down, with the stock and bond markets. Inverse ETFs can protect against market downturns and leveraged ETFs are a way to speculate on the direction of the market price. Then there are options, which offer a way to speculate on individual stocks using relatively small amounts of money.
It is important to always remember that derivatives are volatile, with greater risk of loss — in some cases, unlimited potential for losses. They are complex investments and are not always transparent. You must understand the strategy and risks before investing.
Derivatives are a way to increase the returns on your portfolio, protect yourself from price drops, and diversify with assets such as commodities. There are many ways to invest in derivatives, including through ETFs and mutual funds. Derivatives are a widely used tool in active or day trading. Make sure you understand the strategy and risks before investing or trading derivatives.