What Are Derivatives?
Derivatives are financial instruments for traders. The value of a derivative depends on an underlying asset, like a stock, a commodity, a group of assets, a benchmark, currencies, interest rates, or any other asset for which a broker writes a derivative contract, usually based on client demand.
Derivatives are over-the-counter (OTC) financial instruments and the price of a derivative depends on price fluctuations or it is derived from the underlying asset or assets. Traders can use derivatives to earn money from rising or falling price action. Derivatives trading also benefits from leverage, which can magnify both profits and losses.
Many portfolio managers use derivatives to hedge positions, which is a means of decreasing risk, and to speculate on price action, which involves assuming risk. In addition, derivatives can be used to take advantage of short-term fluctuations within more substantial trends, for example, going long on one asset with a long-term view, but going short on the same asset for short-term gains.
What Types of Derivatives Exist?
Theoretically, there is no limit on derivative types, which explains the estimated value of derivatives exceeding $1 quadrillion. Some estimates have it above $600 trillion as of 2021 (Bank for International Settlements), while the netted value was just above $12 trillion.
The Five Most Traded Types of Derivatives
- CFDs (contracts for difference): CFDs rank among the most traded derivatives for traders. They offer exposure to price action and are leveraged derivatives. They can be without expiry or, in cases where there is an expiry date, they have automatic rollovers. They are straightforward derivatives that are easy to understand and the best trading tool available today.
- Futures contracts: Futures contracts are traded on an exchange and are agreements between two parties to deliver an asset at a future date at the agreed-upon price. They are standardized and legally binding contracts.
- Forward contracts: Forward contracts are similar to futures contracts but are not exchange traded. The two parties can customize the agreement, which is an over-the-counter (OTC) product, but the absence of an exchange results in greater counter-party risk.
- Option contracts: Option contracts are identical to futures contracts except that an option grants the holder the right but not the obligation to exercise it. Therefore, option contracts are more for trading and risk management purposes, while futures contracts fulfill core aspects of supply chain management and operational continuity for parties.
- Swaps: Swaps allow parties to exchange, or swap, cash flows or currency exchange risk. Swaps are highly traded derivatives, vital for inter-bank trading and the effectiveness of the global financial system, and not ideal for retail traders.
What should traders consider before using derivatives?
Trading derivatives can be great for traders, but they must understand the derivatives they trade. Some are straightforward, while others are highly complex.
Here are the core aspects traders should consider before trading derivatives:
- Derivatives are set between two or more parties and may result in a complex financial security
- Derivatives allow traders to access specific markets and trade various assets
- Derivatives are for advanced traders due to their complexity and specifications
- Most derivatives are for stocks, bonds, commodities, currencies, interest rates, and market indexes
- Contract values for derivatives depend on the underlying asset
- Derivatives use leverage
- Traders can use derivatives to hedge a position, speculate on the price action of the underlying asset, or leverage portfolios
- Most derivatives trade over-the-counter (OTC), and traders purchase them via brokers
- Parties that hedge via derivatives do not speculate on price action but manage supply chain risk
- OTC-traded derivatives carry higher counterparty risk, which can result in transaction default
- Some derivatives are legally binding contracts
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The Pros & Cons of Derivatives
Before considering derivatives, traders should consider the pros and cons of derivatives trading.
The Pros of Derivatives Trading
- Parties can lock in prices
- Hedging against price movements
- Risk mitigation
- Leveraged assets
- Portfolio diversification
The Cons of Derivatives Trading
- Financing rates are for holding leveraged products
- Derivatives are hard to value
- Many derivatives are complex and difficult to understand
- OTC trading involves increased counter-party risk
- Sensitive to supply and demand, derivatives resulting in greater volatility
Derivatives Conclusion
Derivatives are vital to the efficiency and functionality of the global financial system and supply chain. They are also ideal for hedging, trading, and diversifying portfolios for institutional, professional, and retail traders.
While derivatives were initially used by market participants to balance exchange rates for international trade, they grew more popular over the past two decades. They manifested themselves at the core of global finance, commerce, and speculation. Some estimates have the value of the global derivatives markets exceeding $1 quadrillion, with an explosive growth rate.
FAQs
What are the four types of derivatives?
While there are more types of derivatives, with CFDs among the most traded ones, the four primary types are forward contracts, futures contracts, option contracts, and swaps.
What is an example of a derivative?
A CFD, or contract for difference is an example of a derivative. Brokers can write one on any asset, and a CFD duplicates price action 1:1 to its underlying asset but does not grant the holder ownership or obligations. For example, a CFD on BP exposes the holder to the upside and downside, adjusted for corporate actions like dividends and splits, without ownership rights, like voting during annual general meetings. Therefore, a CFD is ideal for traders, as they can use leverage, go long, and go short. However, it may be less appropriate for investors.
How to best trade derivatives?
The best way to trade derivatives is through trusted brokers that offer the derivatives contracts traders seek. The geographic location will impact what derivatives are available. For example, tax-free spread betting is available primarily in the UK, the US does not permit CFD trading, and option contracts differ in the US and the EU.