What are Financial Derivatives and How Do They Work?

December 31, 2020 19:00 UTC
Reading time: 15 minutes

When asked about trading, most people will have heard about stocks, bonds and funds. However, the concept of financial derivatives is perhaps more unfamiliar to the general public. In this derivatives guide, we will explain the fundamentals of financial derivative products, including what they are, why they are used and how they can be traded.

A Guide to Financial Derivatives

 

What is a Financial Derivative? Derivatives Explained

What are derivatives in finance? If you have been looking for information on the types of financial derivatives and how financial derivatives work, you're in the right place.

One of the first questions you may ask is, "Are derivatives financial assets?". The short answer is no.

A financial derivative is a security whose value depends on, or is derived from, an underlying asset or assets.

The derivative represents a contract between two or more parties and its price fluctuates according to the value of the asset from which it is derived.

The most common underlying assets used by financial derivative products are currencies, stocks, bonds, stock indices, commodities (i.e. gold and oil) and, more recently, cryptocurrencies.

Many traders are also curious about who invented financial derivatives. Derivatives in finance date back centuries.

Who Invented Financial Derivatives?

To gain a complete understanding of financial derivatives, it's important to understand how they came about.

A brief history of financial derivatives

When were financial derivatives invented? Derivatives are more common in the modern era, but their origins trace back several centuries. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange.

The concept of having a contract for the future delivery of some commodity grew from Mesopotamia outward into Hellenistic Egypt and then into the Roman world. This all occurred before the collapse of the Roman Empire. After their collapse, the Byzantine Empire continued to use contracts for future delivery. Importantly, they did not end with a canon law from western Europe and continued to be used.

Some researchers speculate that Sephardic Jews took derivative trading in Mesopotamia and brought it to Spain during Roman times and into the first millennium AD. In the sixteenth century, they were expelled from Spain, to what was called the Low Countries.

Derivative trading based on securities then continued to spread to England and France from Amsterdam, right around the start of the eighteenth century. From there, in the early nineteenth century, their use continued to expand from France to Germany.

Research has revealed that bankers and banks may have been leading most derivative trading taking place in the eighteenth and nineteenth centuries.

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Before we explore the different types of financial derivative products available, let's look at why people use derivatives in the first place.

Why Use Derivatives?

Why do traders use derivatives in finance? A financial derivative instrument can be used for three main purposes:

  1. To hedge a position
  2. Speculating on the future price of an asset
  3. To leverage a position

In the next few sections, we will look at each of these purposes in more detail.

1. Hedging

One of the main uses of many types of financial derivative investments is risk management and position hedging. Hedging a position is the attempt to minimise the risk of unfavourable movements in the price of an asset. This is usually achieved by taking the opposite position in the same, or a related, asset and can be viewed as an insurance policy against your main position.

Different types of financial derivatives contracts are ideal for this purpose due to their characteristic of allowing traders to profit from falling price movements by what is known as "short-selling".

For example, let's say that an investor bought 100 shares in Company X at $100 per share. A year later, the share price of Company X has risen to $200 per share. However, the investor is concerned that the share price will fall for one reason or another. Instead of selling the shares, our investor may choose to hedge his position by buying a derivative product that will increase in value if the price of the company shares fall.

Taking this action will insure the investor's position against a possible upcoming decline in the price of Company X's shares.

2. Speculation

In addition to hedging, different types of financial derivatives can be used for speculation, with the aim of profiting on the price fluctuations of an underlying asset. Unlike traditional investment products, derivative contracts allow you to profit from price decreases (short-selling) as well as increases (long-selling).

Furthermore, with a derivative investment, a trader is not required to have physical ownership of an asset in order to profit from short-selling the asset.

3. Leverage

Perhaps the most important and attractive feature of trading with different types of financial derivative products is the ability to leverage. Leverage allows traders to open a position by only paying a percentage of its cost.

Therefore, using leverage, a trader can gain exposure in a market that is several times higher than the capital they have in their investment account.

Using leverage in this way allows you to increase your potential profits without increasing your starting capital. However, it is important to bear in mind that leverage also amplifies your potential losses if the market moves against you.

Types of Products

Many different types of financial derivative instruments can be used for different purposes. The majority of the financial derivative market is made up of tailored "over-the-counter" (OTC) derivatives, such as Contracts For Difference (CFDs), but there are also derivatives that are standardised and sold on exchanges, such as futures contracts.

Many traders wonder where to buy financial derivatives. There are two places to buy financial derivatives: over-the-counter (OTC) markets and exchanges.

Since over-the-counter derivatives are traded between two individual private parties, there is a counterparty risk involved in their use. For example, if one of the parties went bankrupt before the contract was settled, they would be unable to fulfil their obligations to the other party.

The types of financial derivatives that are traded on the exchanges are very strictly regulated. However, they tend to require a much larger initial investment, making them less accessible to small and medium-sized investors.

On the list of different types of financial derivatives, there are various choices available to traders. The main ones are:

  • CFDs
  • Futures contracts
  • Forward contracts
  • Options

In the following sections, we will look at each type of financial derivative in more detail.

1. Contracts For Difference (CFDs)

The first product this derivative guide covers is CFDs. CFDs are one of the most popular types of financial derivatives available. A trader enters into a contract with a broker whereby they agree to exchange the difference in price of an asset between the date the contract starts and ends.

The contract usually remains active until it is closed by the trader, or by the broker due to insufficient equity in the trading account.

CFDs provide traders with most of the advantages of a real investment, but without physical ownership of the underlying asset. They also allow traders to take advantage of both increases and decreases in the price by "long-selling" and "short-selling", respectively.

It is possible to trade CFDs on a variety of different financial markets, such as currencies, stocks, commodities, cryptocurrencies and many more.

And, as with most life skills, there is a difference between financial derivatives in theory and practice. And we have good news: you can practice CFD trading without risking your own capital with a demo account from Admirals (formerly Admiral Markets). Click the banner below to open your free account:

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2. Futures Contracts

Futures contracts, or "futures", are another type of financial derivative. These contracts are struck between a buyer and a seller, obligating them to the future exchange of an asset on a specific date at a fixed price. The majority of futures involve raw materials and are traded on large exchanges.

Futures were initially created for producers, such as farmers, who sought to minimise their risk over future price fluctuations of their products. However, since their introduction, futures can now be traded on commodities as well as a range of different financial markets such as Forex and bonds.

The market mostly attracts speculators, who have little interest in acquiring the physical asset referred to in the contract but rather seek to sell the contract for a profit.

Some speculators will even enter and exit positions on a futures contract on the same day, even though most contracts tend to have a duration of three months.

Futures are sold on exchanges and are regulated in the US by the Commodity Futures Trading Commission. All futures contracts are standardised in terms of quality and quantity, meaning that they all have the same specifications regardless of who buys and sells them.

For example, anyone trading oil futures on the New York Mercantile Exchange knows that one contract will consist of 1,000 barrels of West Texas Intermediate (WTI) oil of a certain quality level.

WTI Crude Oil Futures chart

Source: Admiral Markets MetaTrader 5, CrudeOilUS_N1 (WTI Crude Oil Futures), Hourly Chart. Date Range: May 24, 2021, to June 16, 2021. Accessed June 16, 2021, at 15:52. Please note: Past performance is not a reliable indicator of future results, or future performance.

3. Forward Contracts

A forward contract is the next type of financial derivative on this list. Similar to a futures contract, it consists of two parties agreeing to exchange an asset at a future date for a fixed price.

However, unlike futures, forward contracts are customised between counterparties and not standardised. Forwards are considered over-the-counter derivatives, so are not traded on exchanges.

The market for forwards has grown remarkably in recent years, although its precise size is difficult to determine because the contracts are traded in private and the details rarely made public.

Unlike the futures market, the market for forwards is unregulated.

4. Options

Financial derivatives options contracts are a type of derivative that provide their owners with the right to buy or sell (depending on the option type) an underlying asset at a fixed price in a specified timeframe.

Unlike futures and forwards, the owner of options is not obligated to buy or sell the asset if they choose not to do so - they have the option but not the obligation.

The two most common types of options are:

  • Call Options - These allow their owner to purchase an asset at a set price in a specified timeframe
  • Put Options - These allow their owner to sell an asset at a set price in a specified timeframe

All financial derivative options have an expiration date, by which the owner must make their choice as to whether they wish to exercise their rights to buy or sell. The stated price of an option is known as the "strike" price.

With regards to an options "specified timeframe", these are generally divided into two different types of options, European and American. A European option can only be exercised by its owner on the date that the option matures. An American option can be exercised anytime before the maturity date of the option.

To buy the option, the buyer must pay a "premium" fee to the seller for each contract purchased. Therefore, due to the non-obligatory nature of owning an option, the buyer's risk is limited to the cost of the premium fees.

However, the seller of an option carries unlimited risk as they are obliged to fulfil the contract if the buyer chooses to exercise their right.

When a financial derivative option is making a profit, it is said to be "in the money" as opposed to when the option is making a loss and it is "out of the money", or "underwater".

How Did Financial Derivatives Cause the Financial Crisis of 2008?

The proliferation of unregulated financial derivatives back in the years leading up to the 2008 financial crisis played a major role in that crisis.

Many of the people borrowing back then had interest-only loans. These are a kind of adjustable-rate mortgage. Unlike a traditional loan, the interest rates on these loans can rise with the federal funds rate.

When the Fed began increasing rates, the people holding these mortgages suddenly realized that they couldn't afford to make the payments anymore.

This occurred around the same time that the interests rates underwent a reset. 

As interest rates increased, demand in the housing market fell along with home prices. After realizing they couldn't make payments nor sell the house, they defaulted on their loans.

Most importantly, some parts of the mortgage-backed securities (a bundle of mortgages whose value is derived by the value of all the mortgages in it) at the time were worthless. However, no one knew which parts. Since no one fully understood what was in them, they couldn't determine their true value.

Such uncertainty led to the secondary market shutting down. Hedge funds and banks had many derivatives that were losing value and which they couldn't sell. Soon, the banks stopped lending to one another completely. This was because they feared receiving defaulting derivatives as collateral on loans.

As a result, they started holding onto cash to ensure they could pay for daily operations.

This development is what brought about the bank bailout bill. They originally designed it to clean these derivatives from the books so banks could begin making loans again.

Traditional Trading vs Derivatives

Although trading different types of financial derivatives shares many of the same qualities as traditional products, there are some key differences:

  • Traders can open long and short positions with financial derivatives
  • Using financial derivatives, traders can profit from price fluctuations without ever owning the asset - even if they short-sell
  • Trading derivatives benefits from leverage

Of course, trading using different types of financial derivative products also has its drawbacks. In some circumstances, not owning the asset deprives you of certain property rights. For example, if you trade shares using CFDs, you will not receive certain types of dividends and you also do not have voting rights.

A more serious problem lies in the fact that the derivatives market is a lot less regulated than traditional trading products. Therefore, it can attract unregulated or untrustworthy brokers as well as fake brokers looking to scam people.

Therefore, if you are interested in trading different types of financial derivatives, it is important to choose your broker carefully. Stick to brokers who are regulated by a respectable financial body and make sure you read their terms and conditions carefully before opening an account.

Trading Platforms for Derivatives

If you want to start trading using financial derivatives on thousands of markets, MetaTrader 5 is widely regarded as one of the best available platforms for doing so.

Traders can easily track the movement of a wide range of financial assets, such as Forex and CFDs on stocks, commodities and stock indices, to name a few.

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About Admirals

Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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