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Time to read: 5 min
March 29, 2021
Trading in derivatives opens up a new world of speculative possibilities for day traders and swing traders. Financial derivatives are instruments where a lot of money can be made or lost. Throughout this comprehensive guide to derivatives, you can learn about the various categories of derivatives and how to use them.
So, what is derivative trading? In finance, financial derivative instruments are items that, as their name implies, derive their value from something else called the underlying asset. The underlying asset typically includes shares, commodities, bonds, currencies, stock indices, or any other asset.
Stocks, bonds, commodities, currencies, and stock indices are typically the most common types of underlying instruments. In the case of derivative trading, traders don’t trade in the underlying asset. Instead, they’re keeping an indirect position.
As a skilled trader, you have at your disposal various types of derivatives. Each one of them has a prominent style. Derivatives will help you execute several trading strategies, hedge risk, and bet on potential market values.
By far the most common derivative instruments among retailers are CFD Difference Contracts. CFDs allow retailers with smaller accounts to bet on the rise and fall in prices of global assets. CFDs offer a variety of instruments that can be traded as indices, bonds, forex pairs, and commodities.
We will clearly outline the basic criteria for trade-in each form of derivative:
Forward contracts are structured contracts that will help us purchase and sell assets at a date in the future. It’s an informal pre-set price deal because they’re selling on the OTC market. The key advantage of the forward contract is that it helps to freeze the future price of the asset. It’s a good hedging tool against the possibility of adverse reactions. Forward is more popular in the currency market.
Future contracts are equivalent to forward contracts. Futures are financial contracts used to purchase and sell assets at a fixed price and on a date in the future. The key difference is that futures are exchange-traded options, so they’re not traded on the OTC market. Futures have the advantage of closing the price of the underlying asset.
Options contracts are financial contracts that enable investors to buy (call options) and sell (put options) the underlying asset. Each option contract has an expiry date by which the option holder must exercise its option. Options also have a fixed price recognized as the strike price.
Swap contracts are personalized OTC contracts and are not immediately applicable to retail investors. Swaps are financial contracts that allow one asset to be exchanged for another. Swaps help to reduce borrowing costs. Interest rate swaps are the most prominent types of swaps.
Now, let’s look at some of the advantages that come with trading in derivatives.
The biggest advantage of trading in derivatives is leverage. This means that you can trade in margins and just position a small portion of the overall amount exchanged as collateral. Derivatives have opened a new door for speculation. Virtually any protection can be speculated by derivative contracts. You would also be able to have an interest in expensive assets that are otherwise out of control.
The second benefit of derivatives contracts is that you can reduce the price risk. Essentially, it allows savvy investors to hedge cash market investments.
Hedging strategies are very effective in offsetting risks to any adverse price fluctuations. When there are special big risk events, such as earning reports, and you don’t know the result, derivatives can be used to cover the uncertainty.
Exchange-traded options also benefit from increased liquidity. This ensures that you have the opportunity to get in and out of business very easily without impacting the stock price. Abundant liquidity also results in narrow spreads in bids. The final result is that you would have low transaction costs relative to the cash market.
Derivatives are traded on two platforms, Over-the-counter(OTC) market & Exchange-based market.
OTC derivatives are traded off-exchange and traded explicitly between the two parties. The flipside with over-the-counter derivatives is that they are unregulated contracts that are independently negotiated between the two entities involved.
Exchange-traded derivatives are all those contracts that are listed on an exchange such as the Chicago Mercantile Exchange or the CBOE. The biggest exchange of derivatives is the CME Group. Stock derivatives are exchange-based securities offering structured contracts. Exchange-traded derivatives reduce counterparty risks associated with OTC derivatives.
In conclusion, both well-known and active traders use derivative trading for speculative purposes to improve their efficiency or eliminate portfolio risk levels. But, like any kind of investment, derivatives are like a double-edged weapon. Before you use it, make sure you understand how stock derivatives work. If you gain information and analyze the risk, exchange-traded derivatives should be the preferred choice.
Disclaimer: There are potential risks relating to trading and investing and you should not trade with money that you cannot afford to lose however, for those that educate themselves and adopt appropriate risk management strategies, the potential update can be significant. Please note that all opinions, research, analysis, and other information are provided as general market commentary and not as specific investment advice.
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