What are financial derivatives?

Financial Derivatives trading

Derivative contracts are commonly used by the majority of the world’s largest companies, so they can better manage their risk and make their cash flow more steady and predictable. This level of predictability in cash flow and earnings can help boost their stock price. When their price is boosted, they need less working capital. Derivatives work on a small premium, so a company need not have a large amount of cash on hand to invest. Often before the contract has expired, another contract is opened to offset the first.

What is a Financial Derivative? – Derivatives Explained

A financial derivative is a tradable product or contract that ‘derives’ its value from an underlying asset. The underlying asset can be stocks, currencies, commodities, indices, and even interest rates. Derivatives were originally designed to help investors eliminate exchange rate risks, but their utility has grown over the years to help investors not only mitigate various types of risks but also to access more market opportunities. Derivatives are now attractive to many types of investors because they help them to remain exposed to price changes of different financial assets without actually owning them.

Types of Derivatives:

The most common types of derivative contracts are futures, options and CFDs. These are offered either OTC (Over-the-counter) or via an Exchange. The derivative’s value is affected by the performance of the underlying asset and also the contract conditions.

The more common derivatives used in online trading are:

  • CFDs
    CFDs enable you to speculate on the increase or decrease in the price of global instruments like shares, currencies, indices and commodities. When you trade CFDs, you are effectively taking a contract, rather than taking hold of the underlying asset. That means you will be speculating on the price movement, rather than buying the actual asset. With CFDs, you can trade both ways, on both rising or falling markets. That is a big benefit of trading CFDs, rather than buying stocks, for instance.

  • Futures Contract

    This is often used for commodities, shares or currencies to offset risk. A company that needs to receive raw materials in the future, can have a reasonable price locked in. This will protect it from future price hikes. This may also protect a company from future currency exchange rate changes or even interest rate changes. This protects against currency depreciation, especially in terms of exporting products into the local currency. Index futures, like the S&P 500 E-mini Futures (ES) and also currencies, take on board current investor sentiment in order to reflect that into the future pricing, taking on board interest rates. The pricing of these contracts also changes based on the current supply and demand of the underlying asset and of the contracts themselves. They can be offset or liquidated before expiry. Futures are standardised to facilitate trading on the futures exchange such as the Nymex exchange for Gold.

  • Options
    Trading options on the derivatives markets gives traders the right to buy (CALL) or sell (PUT) an underlying asset at a specified price, on or before a certain date. The holder has no obligation to buy the underlying asset. This is the main difference between Options and Futures.

  • Futures vs. Options
    The purpose of both futures and options is to allow people to lock in prices in advance, before the actual trade. This enables traders to protect themselves from the risk of unfavourable prices changes. However, with futures contracts, the buyers are obligated to pay the amount specified at the agreed price when the due date arrives. With options, the buyer can decide to back out of the contract. This is a major difference between the two securities. Also, most futures markets are liquid, creating narrow bid-ask spreads, while options do not always have sufficient liquidity, especially for options that will only expire well into the future. Futures provide greater stability for trades, but they are also more rigid. Options provide less stability, but they are also a lot less rigid. So, if you would like to have the option to back out of the trade, you should consider options. If not, then you should consider futures.

  • Forward Contracts
    Financial instruments that are set up with more of an informal agreement and traded through a broker that offers traders the opportunity to buy and sell specific assets such as currencies. Here too a price is set and paid for on a future date. This contract can also be renegotiated, so extended or closed early for a premium.

  • Swaps
    Swaps are customised OTC contracts between two traders. These aren’t usually traded by retail investors and are not traded over exchanges. A common example of a swap is on interest rates. Swaps are when two parties exchange cash flows or liabilities for two different securities, over a set period of time.

Why Trade Financial Derivatives?

Derivatives can serve many important functions in a portfolio. The first reason to trade derivatives is that they provide the perfect platform for speculating on the price changes of various financial assets. Derivatives allow investors to access markets and opportunities that they could otherwise not have been exposed to.

For instance, one is able to invest in Bitcoin without understanding all the technicalities of buying and securing the digital coins in online or offline wallets. If an investor buys a Bitcoin derivative, they will earn profits when the price of Bitcoin rises without actually owning the digital currency. Investors also trade derivatives to access leverage. Leverage allows investors to boost their capital holdings in the market, effectively amplifying their profits on successful trades. But traders should always use leverage carefully because it also magnifies losses on trades that do not go in your favour.

The structure of derivatives, as well as the availability of leverage, can also help investors to take advantage of arbitrage opportunities in the market. Although uncommon nowadays, arbitrage opportunities arise due to market inefficiencies, such as a similar financial asset being priced differently on different platforms at the same time.

Another important reason to trade derivatives is to hedge risk exposure in the market. This is done by purchasing a derivative that moves in the opposite direction of an asset you own. For instance, if an investor owns Microsoft shares, they can buy a certain type of derivative, based on Microsoft share price, in this case, a Put Option, that earns profits when the price of the stock falls. In this way, the investor would have mitigated the risks of holding the stock when its prices are not appreciating.

Advantages of Derivatives

As tradable products, derivatives allow investors to have potentially lucrative additions to their investment portfolios. They are leveraged products that can help investors spread their capital efficiently in the market and earn boosted profits, although the risks are also increased due to leveraged exposure. Derivatives have also opened up opportunities for the average retail investor, who can now access markets such as global equities, forex, bonds, commodities, and even cryptocurrencies with low fees. These are markets that would traditionally require huge amounts of capital and sometimes even a great deal of expertise.

Derivatives are also used for mitigating risks in the market. They are perfect for hedging strategies and can help investors to offset any risks or potential losses in their portfolios. Because they are leveraged products, derivatives provide a cheap and effective way to hedge against any risks in the market. Leverage also allows investors to use derivatives to earn profits out of marginal price changes in an underlying asset. Because leverage enhances capital, even a fractional price change in the market can lead to big profits or heavy losses for an investor. For this reason, derivatives can be used to trade financial assets even during periods of low volatility or relative price stability.

Disadvantages of Derivatives

Leverage is one of the reasons that make derivatives appealing to investors, but it is also the biggest source of risk. In the same way that leverage can boost profits; it can also magnify losses when the prices of the underlying asset do not go according to your prediction. This makes derivatives particularly risky for trading underlying assets whose prices are inherently volatile.

Derivatives can be difficult to value, especially those that are based on multiple underlying assets. This can make them a tool for gambling rather than effective investor speculation. In derivatives, money is made out of price changes, and not knowing how to price an asset accordingly could expose an investor to higher-than-normal risks. Some derivatives, such as options, are time-restricted. This adds another layer of risk when trading financial assets. It is realistic for an investor to predict that prices of an underlying asset can rise or fall, but it is far more challenging to predict when exactly such a price change will occur.

Derivatives Trading with AvaTrade:

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Financial Derivates main FAQs

  • How are financial derivatives used?

    The most common use for financial derivatives is to manage risk in a financial trade. While many think of risk reduction when managing risk is mentioned, it is also quite common for speculators to increase their risks (and potential profit or loss) through the use of financial derivatives. One common example is in the futures market where farmers will sell futures in order to lock in the price they will receive for their grain or livestock. This is a way to reduce risk. Another example is the use of CFD products for trading. Because of its leveraged nature a CFD can be used to magnify the results of trading in a wide variety of assets.

  • What are some common types of financial derivatives?

    There are a wide variety of financial derivatives that can be used to increase or decrease investment risks. One of the most common is the futures contract, which is an agreement on a future financial transaction on a set date and at a set price. Another type is a swap, where the agreement is to exchange one asset or liability for another. A third commonly used financial derivative is the option, which gives the holder the right, but not the obligation, to purchase or sell an asset at a future time. And finally, there is the contract for difference (CFD) which allows for the exchange of the difference in value of an asset between the time the contract is opened and closed, without owning the underlying asset.

  • What types of underlying markets have financial derivatives?

    Not only are there a wide variety of derivative types, there are also a wide variety of underlying markets that use financial derivatives. We commonly think of the derivatives of commodities, currencies, and equities, but that just touches the surface of financial derivatives. Other markets that use derivatives include the government bond market, short-term debt markets, over-the-counter lending markets, credit risk markets, and various index can also be used as the underlying for a derivatives contract.

We recommend you to visit our trading for beginners section for more articles on how to trade Forex and CFDs.

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