What Is Derivatives Trading: Expand Your Trading Arsenal

15 Price Action Patterns Insiders are Using If a hedge fund managers were using 15 specific price action patterns would you want to know?

Derivatives trading opens a new world of speculative opportunities for day traders and swing traders. Derivatives are instruments that โ€œderiveโ€ their value from an underlying asset i.e. stocks, bonds, gold, oil, cryptocurrencies, etc. If that is confusing to you donโ€™t worry, we are going to make it make sense by the end of this article.

For now, just know that it is possible to make or lose a lot of money, through derivatives trading. This beginnerโ€™s guide to derivatives trading will teach you what derivatives are, the different types of derivatives, and how to trade them.

If this is your first time on our website, our team at Trading Strategy Guides welcomes you. Check out the TSG Blog to find anything you need related to trading.

Attention Beginner Traders, if all of this derivatives talk makes your head spin, you may want to check out our article, What Is Trading: A Comprehensive Beginnerโ€™s Guide to Understanding Financial Markets.

Now, letโ€™s begin!

Intro โ€” Derivatives Trading

In this beginnerโ€™s guide to derivatives, weโ€™re going to give you an in-depth introduction to financial derivatives. This guide is designed to answer the question: what is derivatives trading?

In the aftermath of the subprime mortgage crisis, the worldโ€™s biggest investor of all time, Warren Buffett, also known as the โ€œOracle from Omaha,โ€ labeled derivatives as โ€œfinancial weapons of mass destruction.โ€

Despite his negative comments on derivatives, Warren Buffett took advantage of derivatives trading in a big way, netting him billions of dollars in profit. It seems derivatives trading can also be labeled as a money-making machine.

As the saying goes:โ€ Do not listen to what they say, look at what they do!โ€

Moving forward, weโ€™re going to cover derivative trading and share some valuable tips so youโ€™ll be well-equipped to conquer the global markets with confidence.

What is Derivative Trading?

In finance, derivative instruments are products that, as their name suggests, derive their value from something else called the underlying asset. The underlying asset can be anything like:

  • Shares
  • Commodities
  • Bonds
  • Currencies
  • Stock Indices
  • Or any asset

Usually, stocks, bonds, commodities, currencies, and stock indices are the most common types of underlying instruments. Derivative traders do not invest in the underlying asset. Instead, they hold an indirect position.

Derivatives Trading Instruments
Derivatives trading 3

In essence, any security which has its value determined by another asset is a derivative contract. The instrument from, which a derivative gets its value is called the underlying asset.

The most important thing to keep in mind is the fact that the value of a derivative contract is depending upon the value of something else.

To make things clear, letโ€™s use an example from the day to day life. Without even knowing it, people are using derivatives. In a wide sense, derivatives are an agreement between two parties. For example, you want to buy a limited edition car that requires a $10,000 deposit to join the waiting list. The car is only going to be released a year later and all the cars that are going to be produced are sold, so the queue list is closed.

If you change your mind and donโ€™t want the car you can sell your place in the queue to other buyers. If you find another car fanatic who missed the opportunity and you can agree to sell your place in the queue for a higher price of $11,000, which otherwise he wouldnโ€™t have had the chance to buy the car. Traders are not purchasing the car themselves, they are purchasing an asset whose value is connected to the car.

Roughly speaking, this trade represents a derivative trade, more precisely a call option. Paying the $10,000 premium to be in the queue for something that will be delivered in the future is comparable to options trading.

Types of Derivative Instruments

We can distinguish five basic types of derivative contracts:

  • Futures
  • Forwards
  • Options
  • Swaps
  • CFDs (Contract for Difference)

Each type of derivative contract can also come with many variations.

Exchange Traded Derivatives
Derivatives trading 2

As a professional trader, you have different types of derivatives at your disposal. Each of them has a distinctive feature. Derivatives can help you implement different trading strategies, hedge the risk, and to speculate future price values.

Below you can find a detailed description of the main types of derivatives:

  1. Forward contracts: are standardized contracts that can help derivative traders buy and sell assets at a future date. Itโ€™s an informal agreement with pre-set prices, so they trade on the OTC market. The main benefit of a forward contract is that it helps freeze the future price of an asset. So itโ€™s a good hedging tool against the risk of an adverse movement. Forwards are more popular in the currency market.
  2. Future contracts: are similar to forward contracts. Futures are financial contracts used to buy and sell an asset at a predetermined price and a future date. The main difference is that futures are exchange-traded derivatives, so they are not traded on the OTC market. Futures have the benefit of locking in the price of the underlying asset. Examples of future contracts: E-mini, CL, GLD, ZN.
  3. Options contracts: are financial contracts that allow investors to buy (call options) and sell (put options) the underlying asset. Each option contract has an expiration date by which the option holder must exercise their option. Options also have a pre-determined price known as the strike price.
  4. Swap contracts: are customized OTC contracts that are not directly available to retail investors. Swaps are financial contracts that allow the exchange of one asset for another. Swaps help minimize borrowing costs. The most popular form of swaps is interest rate swaps.
  5. CFDs: CFDs allow retail traders with smaller accounts to speculate on the rise and fall in prices of global assets. CFDs offer a range of instruments that can be traded like indices, shares, forex pairs, and commodities. Also Read โ€“ Is trading CFDs illegal for US traders?

Letโ€™s now look at some of the benefits that come with derivatives trading.

How Derivatives Trading Can be Profitable?

The main benefit of derivatives trading is leverage. This means that you can carry margin trading and only put as collateral a small portion of the total amount traded. Derivatives opened up a new door for speculation. You can speculate on virtually any security using derivative contracts. You will also be able to have a stake in expensive assets that are otherwise out of reach.

The second advantage that comes with derivatives contracts is that you can mitigate the price risk. In essence, it helps sophisticated investors hedge cash market investments.

Hedging strategies are very useful in offsetting the risk against any adverse price movements. When there are special major risk events like earning reports and you donโ€™t know the outcome, one can use derivatives to hedge that uncertainty.

For example, a derivatives trader who has a long position in the S&P 500 (the American stock market index) and wants to protect his trade from a risk-aversion scenario, can buy put options on the S&P 500 index futures. A put option gives the buyer the option to sell a certain amount of the S&P 500 at a specified price within a specified time frame. By doing this, the trader decreases the risk of the original position.

With derivatives, you can mitigate the market risk from risk-averse investors to those investors with a higher appetite for risk.

Exchange-traded derivatives also get the benefit of bigger liquidity. This means you have the ability to get in and out of trades very quickly without affecting the market price. Abundant liquidity also results in narrow bid-ask spreads. The end effect is that youโ€™ll have low transaction costs as compared to the cash market.

The next paragraph is a detailed guide on where to buy and sell derivative instruments.

See below:

Where to Trade Stock Derivatives

Stock derivatives can be bought or sold in two places:

  • Over the Counter Market OTC.
  • Exchange-based.
Derivatives Trading
Derivatives trading 4

You can learn more about the characteristics of the OTC market with our guide: Over-the-Counter Trading โ€“ How the Whales Trade.

In essence, OTC derivatives are traded off-exchange and are traded directly between two parties. Itโ€™s estimated that the OTC derivatives market is approximately $1.2 quadrillion in size. OTC derivatives are very popular among investment banks.

The downside with over-the-counter derivatives is that they are unregulated contracts that are negotiated privately between two entities involved.

The exchange-traded derivatives are those contracts listed on an exchange such as the Chicago Mercantile Exchange or CBOE. Actually, the biggest derivatives exchange is the CME Group. Stock derivatives are exchange-based instruments that offer standardized contracts. Exchange-traded derivatives eliminate the counterparty risk associated with OTC derivatives.

The common practice is for small investors to trade derivatives via an exchange while institutional trader to buy OTC derivatives.

The main difference between exchange-traded derivatives and over the counter derivatives are outlined in the figure below:

Stock Derivatives
Derivatives trading 1

How Derivatives Work in the Stock Market

This is how derivatives work:

  • Speculation
  • Or Hedging

The most popular exchange-traded derivatives are stock derivatives, namely options. A stock option works very simply. Stock options give you the right to buy (call) or sell (put) stocks at a specific price and time in the future.

For example, if Apple stock is trading at $150 per share, a call option can provide the buyer the right to buy shares of Apple at โ€“ letโ€™s say โ€“ $160 any time between the time the call option contract was bought and the expiration date. If the time frame is 1 month, the option holder can make money if Apple stock rises in price. Options can be purchased at, above, or below the current price.

If one month from now Apple stock trades at $180 per share, the option holder can purchase Apple stock at a discount to the market rate. But, since the option contract is more valuable now, the option buyer can sell the contract in the open market for a bigger profit.

A stock option is a derivative because the option value is derived from the underlying stock. Learn how to paper trade options here.

In basic terms, weโ€™re going to outline how derivatives work in the real world.

For example, farmer Joe grows wheat every year. Because he grows wheat and because he is looking at the spot price of wheat itโ€™s not clear to him what the final price will be when the crop will be ready for harvest. Farmer Joe, wonโ€™t know whether he is able to turn a profit, therefore he faces a perpetual risk. Due to the price predictability they produce, derivative contracts are popular in the agricultural industry.

The question is if there is a way to protect or hedge against the risk of wheat price uncertainty. Thatโ€™s where derivatives come in. Farmer Joe has the potential to lock in an arrangement to remove the wheat price uncertainty by using the futures market.

Exchange Traded Derivatives
Derivatives trading 5

For example, farmer Joe can agree to deliver 100 bushels of wheat at an agreed price and date in the future. Now, farmer Joe can better plan his business and remove some of the risk associated with the fluctuation of wheat price.

The speculative activity that takes place in the derivatives market gives farmer Joe the needed liquidity to sell his 100 bushels of wheat. In exchange for the potential profit offered by derivatives, speculator provides the much-needed liquidity to the market which plays an important role.

Conclusion โ€“ Derivatives Trading

In summary, all famous and successful investors use derivatives trading for speculative reasons to boost their performance or to mitigate portfolio risk levels. But, like with any type of investment, derivatives are like a double-edged sword. Before you use them, make sure you understand how stock derivatives work. Once you gain the knowledge and assess the risk, exchange-traded derivatives should be a preferred option.

Exchange-traded derivatives remain the safest play as they are more transparent and offer more liquidity than OTC derivatives. For speculation purposes, exchange-traded derivatives are also more popular, so make sure you first understand how they work before you get your feet wet.

Also, read this guide on how to Day Trade ETFs.

Thank you for reading!

Feel free to leave any comments below, we do read them all and will respond.

Further Reading

If you enjoyed this Derivates Trading Guide, you may also want to read up on the following:

  • What is Trading: Beginnerโ€™s Guide to financial markets, itโ€™s a great place to start if youโ€™re not sure where to begin.
  • Futures Trading Guide: All you need to know about futures, get started as a futures trader in no time.
  • Options Trading Guide: Been wondering about how to get a boost from options? This is a great place to start.
  • Stock Trading Guide: One stock to rule them all, find out how to make a daily profit from the markets by trading one stock!
  • Prop Trading Guide: Interested in becoming a full-time professional trader? Weโ€™ve made it easy with this comprehensive guide.

Frequently Asked Questions

What is derivatives trading?

Derivatives Trading - What Is Derivatives Trading

Derivatives trading involves buying and selling financial contracts whose value is based on an underlying asset or group of assets. Derivative instruments are related to an underlying asset like, stocks, bonds, indices, commodities, currencies, or even other derivatives.

What are the 5 main types of derivatives?

Derivatives Trading - Main Types Of Derivatives

There are five main types of derivatives: futures contracts, forwards contracts, options contracts, swaps contracts, and contracts for difference (CFD).

Is derivatives trading hard?

Derivatives Trading - Is It Hard

Derivatives trading can be complex and requires a good understanding of financial markets and instruments. However, with proper education, practice, and sound risk management rules in place, anyone can learn to trade derivatives.

Are ETFs a derivative?

Derivatives Trading - Are Etfs Derivatives

ETFs are not considered derivatives. They are not contracts between two parties. ETFs are more similar to mutual funds but are traded on an exchange like a stock.

What is swaps trading?

Derivatives Trading - What Are Swaps

Swaps trading involves two parties exchanging cash flows based on different financial instruments or currencies.

What are the benefits of derivatives trading?

Derivatives Trading - Benefits Of Derivatives Trading

Derivatives trading allows investors to hedge against risk, speculate on price movements, and gain exposure to various asset classes.

How can I get started with derivatives trading?

Derivatives Trading - How To Get Started

You can begin by researching which type of derivative you are most interested in. Open a brokerage account that offers your desired derivatives and practice with a demo account before trading with real money. As always, education is a key component to getting started with any financial endeavor. Reading books, taking courses, and following reputable bloggers are all good ways to educate yourself.

Derivatives Trading PDF Download

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Derivatives Trading Strategy Infographic
Derivatives trading infographic 1

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15 Price Action Patterns Insiders are Using If a hedge fund managers were using 15 specific price action patterns would you want to know?

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