Derivatives: The Complete Guide

Asset classes

Derivatives
  • Derivatives are financial securities that have a value dependent or gotten from an underlying asset or group of assets.
  • Derivatives can either trade on an exchange or over-the-counter (OTC).
  • Multiple types of derivatives exist: futures, forward contracts, swaps or options.

Derivative markets serve vital functions in the financial system. Although derivatives can be complex, they show the modern day versions of practices that have been around for several centuries. When traders place bets with one another or farmers would agree to sell their farm produce in advance as a form of insurance.

For individual investors, derivative trading has opened up a vast range of markets for them. It has made it possible for them to speculate when price will rise or fall. But investors need to fully understand derivative markets before they can trade them. They should also know the different derivative products that are available.

What is a Derivative?

This is a financial security that has a value dependent or gotten from an underlying asset or group of assets. The derivative is a contract between two or more people. It derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are bonds, stocks, interest rates, currencies, commodities, and market indexes. Traders can buy these mostly through brokerages.

Derivatives can either trade on an exchange or over-the-counter (OTC). OTC derivatives make up a higher part of the derivatives market. Such derivatives have a greater possibility of counterparty risk.

Counterparty risk is the danger that one of the entities involved in the transaction might default. These entities trade between two private parties and are not regulated. On the other hand, derivatives that are exchange-traded are standard and more heavily regulated.

The basics of a Derivative

Derivatives can hold a position, predict on the directional movement of an underlying asset, or give leverage to holdings. They get their value from the fluctuations of the values of the underlying asset.

Originally, people use them to ensure balanced exchange rates for goods traded on the international stage. With the different values of national currencies, international investors needed a system to account for variations.

Today, derivatives depend on a wide range of transactions and have many more applications. There are even derivatives based on weather information. An example is the amount of rain or the number of sunny days in a location.

A brief history of Derivatives

Derivatives have existed for a long time now. But their markets only got bigger in the 1980s. This was a time of financial deregulation.

As their market grew in the 1990s and 2000s, more complicated derivatives than the simple ones became widely used by banks. They intended to reduce their operational risk. Some examples of these complex derivatives include credit default swaps, structured products, and exotic options.

Derivatives are beneficial because they bring liquidity to markets. They do this by attracting traders who take on risks more than other individuals.

The increased liquidity provided by investors contributes to lower price volatility. It also contributes to a reduced spread between the bid prices and ask prices for an asset. Bitcoin trading became popular by 2011 and the first cryptocurrency derivatives exchanges came up. They include ICBIT, Bitoption, and 1Broker.

Traditional exchanges, like the Chicago Board Options Exchange (CBOE) and the CME, finally began noticing bitcoin in December 2017 and came up with their own futures contracts.

Who should trade Derivatives?

A good understanding of markets and trading are a must. If you can’t trade profitably in spot markets, you are probably not ready to trade derivatives.

You need to know technical analysis, fundamental analysis, and risk management before you trade derivatives.

How to trade Derivatives

Investors can trade derivatives in two different ways. The first is over-the-counter (OTC) derivatives. They see the terms of the contract negotiated privately between the parties involved, in an unregulated market.

The second way to trade derivatives is through a regulated exchange that provides standardized contracts. It offers the benefit of having the exchange act as an intermediary. It helps investors avoid the counterparty risk that comes with unregulated OTC contracts.

There are many derivative products, all having major differences that are necessary for traders to understand. Below are some of the most widely used derivatives:

  • Contracts for difference (CFDs): They are an agreement between two parties to pay the difference in the price of an asset between the time a position opens and when it closes
  • Options: They give traders the right to buy or sell an asset at a particular price within a particular timeframe

Types of Derivatives

There are different types of derivatives that you can trade. They all have unique qualities that distinguish them from one another. Also, investors use them for different reasons.

Futures and forward contracts are both to predict and trade on the future price movements of an asset. It is also used as a hedging mechanism. Options make it possible for traders to hedge against potential price declines.

Conversely, traders use swaps as a way to hedge against risks surrounding debt, foreign exchange movements, and fluctuations in the prices of commodities.

The main types of derivatives include:

Forward contracts

A forward contract has to do with a buyer and seller. Both of them agree to trade an asset at a future date, but at an agreed price that.

Both settle the on the agreed future date, when the buyer pays for the asset at the agreed price. The profits and losses appear based on the movement in price of the underlying asset between the start date and end date of the contract.

Futures contracts

They are an agreement between two parties for buying and delivering an asset at an agreed price in the future. Traders will use a futures contract to hedge their risk or predict the price of an asset. The parties involved in the futures transaction must fulfill a commitment to buy or sell the underlying asset.

Options contracts

They give one party the right to buy or sell an asset to another at a future date at a set price. If the contract provides the option for one party to sell an asset, that is a put option. If it provides the option to buy, it is a call option.

Swaps

These are a totally different kind of derivative involving two parties. Both parties exchange their cash flow, or a variable linked with different assets.

For instance, an investor might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan. It can also work the other way round.

Benefits of Derivatives

As discussed above, derivatives can be a vital tool for businesses and investors. They give a means to lock in prices, hedge against unfavorable movements in rates, and reduce risks. Also, traders can buy them on margin – that is, with borrowed money. This makes them even less expensive.

Downside of Derivatives

It can be difficult to value them because they dependent on the price of another asset. There are risks involved for OTC derivatives, such as counter-party risks. These are hard to predict or value.

Most derivatives are sensitive to changes in the amount of time to expiration, cost of holding the asset, and interest rates. These variables make it hard to match the value of a derivative with an asset.

In conclusion

Derivatives are financial contracts based on an underlying asset enabling traders place leveraged bets. They can also hedge against price volatility and arbitrage across different markets. To successfully trade derivatives, investors should understand the risks involved, have a good knowledge of the instrument, and use sensible risk management techniques.

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