A derivative is a financial contract whose value is dependent on an individual asset or group of assets. A derivative determined by a number of parties and can be traded on an exchange or over-the-counter (OTC). The price for a derivative “derives” from the underlying asset, which is how they get their name. Derivatives are commonly used to access specific markets or to be used as a hedge against risk.
A derivative is a complex type of financial security designed to allow for trading beyond the mere current price of an instrument. Contract values depend on changes in the prices of the underlying asset as well as market sentiment, volatility, trading volume, and other forecasting. The most common underlying assets for derivatives are equities, bonds, commodities, currencies, interest rates, and indices. Financial derivatives mirror the price activity of financial instruments that are traded in the markets.
Types of derivatives
Contracts for Difference (CFDs)
CFDs are the the most popular derivative trading instruments. A CFD enables you to speculate (wager) on prices of financial instruments. CFDs mirror the price movements of the underlying product. CFDs will be explained in more detail in What is…? Episode 8.
Futures contracts are an agreement to buy or sell assets at a specific point in time. These are usually commodities, however futures can include equities, currencies, and cryptocurrencies. Futures will be explained in more detail in What is…? Episode 9.
Options trading on derivatives markets uses similar pricing to futures, however the method of trade is significantly different. This type of trading is a niche skill set all of its own. Options will be explained in more detail in What is…? Episode 10.
Forward contracts are created by an informal agreement between parties, and traded over-the-counter via a broker. With forward contracts, as with futures and options, a price is set and paid for on a future date. Forwards contracts are generally highly specific agreements between discrete individuals for specific purposes. An example of a forward contract is an agreement for a wholesaler to purchase a certain quantity of grain at a certain price before the farmer has even begun to grow it.
Swaps are one of the types of derivatives that are more familiar to the beginner trader, although they are not always understood to be derivatives. Swaps allow two parties in a trade to exchange specific payments for a specified amount of time. They aren’t standardized amounts, instead they are a customized contract between the two parties to the trade. Swaps are a common way for brokers to cover the loan of traded funds to a retail trader by predetermined interest payments.
The way to trade a derivative depends greatly on the type of derivative being traded. More detail on specific derivatives and how to trade them will be provided in the next few episodes in the What is…? series. Generally speaking though, trading a derivative is very similar to trading the underlying product. With CFDs it is almost identical while with futures there is an added layer of “what might the price be in the future?” Options trading includes the future price conundrum, combined with the question of how much you are willing to pay for the chance to buy or sell at that future price. There are different layers of complexity, but it always comes back to ‘what is the value of the product?’
Financial derivatives contracts are usually settled by net payments of cash. This often occurs before the end of the term of the contract. However, some financial derivative contracts, particularly those involving commodities, are an active part of the buying an selling by primary producers and manufacturers. This is the real world, tangible, exchange of products that allow retail traders the opportunity to trade in the first place.
Reasons to trade financial derivatives
The initial need for derivatives was to create balance for goods and services traded globally. Globalization resulted in complications for international trade due to the different currencies, systems, and regulations. Derivatives were intended to be the solution.
These days, those initial complications are far less of a concern, however derivatives trading has now become more of a speculative enterprise. They can also be used by large institutions to hedge themselves against price volatility. Hedging will be explained in more detail in Cut Loose…! Episode 17.
Derivatives provide a unique new way to speculate on the rise and fall of the value of an asset. Trading the current price action is the original “vanilla” way to trade products, however derivatives provide an extra layer of complication that can be very profitable for those who know how to use it. Options trading on derivatives markets opens up even more trading strategies for those who can master them.
Series 1 – What is…?
Episode 6 – Derivatives
Next – ETFs