Derivatives trading opens a new world of speculative opportunities for day traders and swing traders. Stock derivatives are instruments where it is possible to make or lose a lot of money. Throughout this beginner’s guide to derivatives, you’ll learn the different types of derivatives and how to use them.
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In this beginner’s guide to derivatives, we’re going to give you an in-depth introduction to financial derivatives. This guide is pre-planned to answer the question: what is derivatives trading.
In the aftermath of the subprime mortgage crisis, the world’s biggest investor of all time, Warren Buffett is also known as the “Oracle from Omaha,” labeled derivatives as “financial weapons of mass destruction.”
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:” Do not listen to what they say, look at what they do!”
Moving forward, we’re going to cover derivative trading and share some valuable tips so you’ll be well equipped to conquer the global markets with confidence.
What is Derivative Trading?
In finance, the 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:
- Stock Indices
- Or any asset
Usually, stocks, bonds, commodities, currencies, and stock indices are the most common types of underlying instruments. With derivative trading, traders do not invest in the underlying asset. Instead, they hold an indirect position.
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, let’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 don’t want the car you can sell your place in the queue to other buyers. If you find another car fanatic who missed on the opportunity and you can agree to sell your place in the queue for a higher price of $11,000, which otherwise he wouldn’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 four basic types of derivative contracts:
Each type of derivative contract can also come with many variations.
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, to hedge the risk and to speculate future price values.
By far, the most popular derivative instruments among retail traders are Contracts for Difference 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.
Below you can find a detailed description of the main types of derivatives.
We’re going to simply outline the basic requirement to trade each individual type of derivatives:
- Forward contracts: are standardized contracts that can help us buy and sell assets at a future date. It’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 it’s a good hedging tool against the risk of an adverse movement. Forwards are more popular in the currency market.
- 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. Example of future contracts: E-mini, CL, GLD, ZN.
- 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.
- 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.
Let’s now look at some of the benefits that come with derivatives trading.
Why 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 don’t know the outcome, one can use derivatives to hedge that uncertainty.
For example, a 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, he 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 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 you’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.
Where to Trade Stock Derivatives
Stock derivatives can be bought or sold in two places:
- Over the Counter Market OTC
You can learn more about the characteristics of the OTC market with our guide: Over-the-Counter Trading – How the Whales Trade.
In essence, OTC derivatives are traded off-exchange and are traded directly between two parties. It’s estimated that the OTC derivatives market is approximately $1.2 quadrillion in size. OTC derivatives are very popular among investment bank.
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:
How Derivatives Work in the Stock Market
This is how derivatives work:
- 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 – let’s say – $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.
In basic terms, we’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 it’s not clear to him what the final price will be when the crop will be ready for harvest. Farmer Joe, won’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 the wheat price uncertainty. That’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.
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 – Exchange Traded Derivatives
In summary, all famous and successful investors use derivatives trading for speculative reasons to boost their performance or to mitigate the 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 the 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.
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