Derivative Trading: Definition, Types, And Pros & Cons
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Investing has grown exponentially in popularity over recent years. With technology becoming increasingly prevalent in our everyday lives, it’s no surprise that people look for ways to invest their money online. Investors and forex traders have a lot of options when it comes to choosing the right financial instrument. They can choose between several trading options like currencies, different stocks, commodities, indices, derivatives markets, and more.
Derivatives are one of the most popular investment tools available today. Derivative trading is an investment that gets its value from an underlying asset. As a result, derivatives trading has opened up a wealth of new marketplaces for individual traders, allowing them to speculate if any stock is rising or falling. Traders must, however, have a thorough knowledge of derivatives markets before they can trade them.
To better understand Derivative Trading, we have got Ezekiel Chew to share his credibility on the topic and provide us with an in-depth guide. He is the founder and CEO of Asia Forex Mentor, a leading forex education company. With over a decade of trading experience, Ezekiel has helped thousands of traders worldwide achieve financial freedom through forex trading. This expert guide will explore derivative trading, its types, pros and cons, and more.
So let’s get into details.
What is Derivative Trading
A derivative is a contract between two parties that derives its value from an underlying asset. The most common types of underlying assets are stocks, commodities, currencies, and indexes. Derivatives can be used for various purposes, including hedging, speculation, and arbitrage.
Derivatives trading is the act of speculating on the future price movement of an underlying asset. If you are a derivative trader, you are essentially betting that the price of an asset will go up or down. It allows you to take long and short positions on assets without owning them. This type of trading is very popular because it enables traders to make money whether the market is going up or down.
However, keep in mind that derivative trading can be very risky. You can lose a lot of money if you don’t know what you’re doing. That’s why it’s important to understand the different types of derivatives, how they work, and the risks involved before you start trading.
What are Derivatives
Derivatives are financial contracts with value derived from an underlying asset (asset class, stock, commodity). The value or price of a derivative is determined by the underlying asset, which makes it volatile and unpredictable.
Investors can trade derivatives through a broker in an over-the-counter (OTC) manner. This means that derivatives may be transferred to third parties, which makes them more decentralized than typical financial products. They can, however, still be traded on a centralized exchange.
Derivatives often hedge an investor’s risk, boost yield, or minimize losses while trading the underlying asset. Because they allow investors to leverage their potential for risk and returns, they are more dangerous than other financial instruments.
Suppose a trader purchases a certain kind of stock every month. Then, he contracts with a broker to allow him to buy the stock at a set price over the following few months. According to this agreement, it is considered a derivative contract, which may be traded from one party to another.
Types of Derivatives
There are two common types of derivatives.
Right Contracts: The derivative contracts have the right to buy and sell the underlying asset. An options contract is the best example.
Obligation Derivatives: These derivative contracts must buy or sell an underlying asset. An example would be swaps and futures contracts.
Futures Contracts
Futures contracts are the most popular type of derivative. They are standardized contracts to buy or sell an asset at a set price on a specific date in the future. Futures contracts are traded on exchanges and are regulated by governments.
Without exception, all parties to a futures derivatives deal are obligated to fulfill the terms of the contract. For example, this might be an obligation to acquire a specific commodity, currency, option, or index at a given price and date.
For example, take company K, which sells wood, and company L, which produces paper. Company K sells wood as a raw material to Company L. Let’s assume that Company K sold wood for $1 per foot in the previous year. Because company L believes that the price of wood will rise over the next six months, it enters into a futures contract to acquire wood for $1 per foot for one year.
Company L protects itself by insuring against the risk that company K will have to sell wood at $1 per foot, regardless of what happens to the cost of wood. Company K is required to sell them the wood for $1 per foot, no matter how much the price of wood rises. If company L doesn’t need the wood before the year ends, they can sell the derivatives contract to company M and keep the money.
Company L and the derivatives vendor hedge their risk level. For example, to ensure that they would still be able to obtain wood for the same price, Company L assured them that if they needed it for the rest of the year, they would get it. Likewise, the derivatives seller hedges risk by providing that, even if the price of wood fell, they could sell it at $1 per foot.
However, in certain cases, both parties to a futures exchange contract are speculators with opposing views on the price movement of a specific commodity. As a result, one party will profit from the contract, while the other will suffer losses in such cases.
Options Derivatives
An option is a contract that conveys the right, but not the obligation, to buy or sell an underlying asset at a set price on a specific date. It is somehow the same as futures, but the buyer has the option of fulfilling the agreement to buy or sell the underlying financial asset rather than being obligated to do so.
The buyer of an options contract only promises to purchase or sell the underlying asset by a certain future date if the option is exercised. Options allow purchasers to buy or sell a stock at a specified price. The strike price is the most common term for this price.
To put it another way, assume that trader X has purchased 500 shares of stock in firm Y. The value of each share was around $100 when the purchase was made. Due to a leadership change at company Y, the trader believes the shares will rise in price. However, the trader has been wrong in the past and wishes to reduce his risk by hedging his holdings. Therefore, to manage risk, he will acquire a put option to sell each share at $100 within a specified period.
The trader may sell the shares at the original price of $100 if the stock’s value dips to approximately $80 before the deadline expires. In this situation, the trader will just lose the cost of the option derivative. This is a considerably lower loss than had he not purchased the put option.
A trader who believes that a firm’s stock price will rise might buy a call option. For example, trader Z may believe that the stock price of company Y will surge, so he could purchase a call option giving him the right to buy the stock at $100 before the set deadline. Trader Z would have an opportunity to acquire $120 worth of shares for just $100 each if the stock value increased to $120 per share.
Swap Derivatives
A business may trade its variable-rate debt for another company’s fixed-rate debt. This derivative form is frequently used to protect against interest rate changes. The three most common types of say you believe that the price of gold will go up in the next swap are interest rate swaps, commodity derivatives swaps, and credit default swaps. These derivative contracts involve the exchange of two assets between two parties.
Let’s suppose Company A takes out a loan of $50,000 with a four-percentage-point fixed interest rate and is required to pay the same amount each month. They then discover that their interest rate could rise due to a policy change, resulting in higher credit costs. They determine to engage in a swap with Company B to minimize the risk of the potential loss. Company B is prepared to exchange the variable-rate payments for the fixed-rate payments owed on a 5 percent loan.
A will pay 5% to B on its $50,000 principle, and Company B will pay Company A a 4% interest on the same principle. At the start of the swap, Company A will just send Company B the 1% difference between the exchange rates.
Even though interest rates vary, the objective of a swap derivative contract is to convert a variable interest loan into a fixed rate loan.
Forwards Derivatives
A forward contract is a type of futures contract only traded over the counter. In most cases, forward contracts are frequently decentralized and do not fall under any trading rules.
As a result, they pose a large financial risk of default by one party. This is known as counterparty risk. If the situation arises in which one party is unable to fulfill their obligation for whatever reason, the other party loses money.
However, these derivatives may be sold to a third party at any time. The chance of counterparty risk rises as more individuals become involved in a contract.
Pros and Cons
Pros
Below are a few of the most common advantages of trading derivatives:
- Futures derivatives allow you to guarantee a price for an underlying asset ahead of time, which is especially useful when the underlying asset price is expected to rise. This is a big benefit for investors since they may save much money on capital.
- Options are extremely useful in reducing financial risk. This allows you to keep a short position for as long as possible and either make a great profit or just lose the cost of the derivative.
- Swaps are perfect for investors who speculate on interest rates. This is because they can be used to adjust the cash flows of an investment portfolio.
Cons
Derivatives trading is not as famous as other methods as it is not something everyone can do. Below are a few of the disadvantages:
- Because they are complex financial products, especially options and swaps, it can be very difficult to understand how they work. Unfortunately, this lack of understanding can lead to big losses.
- Unlike other financial contracts, there is no centralized exchange for derivatives. As a result, finding a buyer or seller can be hard when you want to exit a position.
- Derivatives are high-risk, high-reward financial contracts with significant market volatility. As a typical trader, you’ll need prior trading expertise and experience to trade derivatives. They aren’t the finest financial markets for novices.
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Ezekiel Chew has been a professional Forex trader and mentor in the financial markets since 2005. He is the founder and CEO of Asia Forex Mentor, a company that provides Forex trading education and mentorship to individuals around the globe.
Ezekiel is known for his unique and highly effective Forex trading methods, which are backed by mathematical probability. He has helped thousands of students worldwide achieve financial freedom through Forex trading. His core program, “AFM PROPRIETARY ONE CORE PROGRAM,” is a complete program that covers everything from beginner to advanced and has been used by banks and trading institutions worldwide.
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Conclusion: Derivative Trading
Derivative trading is one of the best ways if you want to grow your portfolio and safeguard your assets from dipping or diversifying. The most popular technique for average traders is exchange-traded derivatives (also known as ETFs) and mutual funds. These two are investment funds that show the various underlying assets and are easy for most investors to comprehend.
But before you get started with the derivatives market, it is best to understand how it works before diving in, and always use stop-loss orders to limit your downside risk. Also, research the company you plan on investing with, as there have been past fraud cases. Overall, trading derivatives is a great way to make extra money and grow your portfolio if done correctly. However, financial advisors only recommend this trading strategy to firms and professionals.
Derivative Trading FAQs
Is Derivative Trading profitable?
Yes, derivative trading can be profitable if you have the right knowledge and expertise. However, it is also risky and volatile, and many people lose their cash just because they start with no knowledge or prior experience. So, to make your derivative trades profitable, you must ensure that you get the key concepts.
Are Derivatives regulated?
The Security Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) regulate different derivatives, such as futures and options. Other derivatives, such as forwards, are entirely over-the-counter (OTC derivatives) and are completely irregulated. This is because they are mostly created privately between two parties and are not standardized.
