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A Guide To Financial Derivatives

July 14, 2020 12:47 UTC

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 article we will explain what financial derivative products are, why they are used and how they can be traded.

A Guide to Financial Derivatives

What are Financial Derivatives?

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.

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

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Why Use Derivatives?

A financial derivative 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.

Hedging

One of the main uses of derivative products is for 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.

Financial derivatives 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.

Speculation

In addition to hedging, financial derivatives can be used to profit on the price fluctuations of an underlying asset. Unlike traditional investment products, derivatives allow you to profit from price decreases (short-selling) as well as increases (long-selling). Furthermore, a trader is not required to have physical ownership of an asset in order to profit from short-selling the asset.

Leverage

Perhaps the most important and attractive feature of trading with 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 Financial Derivative Products

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

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.

Derivatives which 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.

There are various financial derivative products available to traders, the main ones are:

  • CFDs
  • Futures contracts
  • Forward contracts
  • Options

In the following sections we will look at each of these in more detail.

Contracts For Difference (CFDs)

CFDs are one of the most popular forms 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.

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Futures Contracts

Futures contracts, or "futures", 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 on 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.

Crude Oil Futures Chart MetaTrader 5Source: Admiral Markets MetaTrader 5, CrudeOilUS_ZO (WTI Crude Oil Futures), Hourly Chart. Date Range: 24 June 2020 - 13 July 2020. Accessed 13 July 2020 at 15:52. Please note: Past performance is not a reliable indicator of future results, or future performance.

Forward Contracts

A forward contract is similar to a futures contract in that 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.

Options

Options 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 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.

In order 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 an 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 "under water".

Traditional Trading vs Derivatives

Although trading derivatives share many of the same qualities as traditional products, there are some key differences:

  • Traders can open long and short positions with derivatives
  • Using 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 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 with 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.

The MetaTrader 5 Supreme Edition (MT5SE) is an add-on for MetaTrader developed by Admiral Markets. Thanks to the MT5SE add-on, you can have access to 60+ additional features which are not offered in the stand alone platform.

The good news is that both MetaTrader 5 and the MT5SE add-on are free to download for customers of Admiral Markets!

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About Admiral Markets

Admiral Markets 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.