There are many types of derivatives and they can be good or bad, used for productive things or as speculative tools. Derivatives can help stabilize the economy or bring the economic system to its knees in a catastrophic implosion.
What Is a Derivative?
A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset (like a security) or set of assets (like an index).
Derivatives are tradable products that are based upon another market. This other market is known as the underlying market. Derivatives markets can be based upon almost any underlying market, including individual stocks (such as Apple Inc.), stock indexes (such as the S&P 500 stock index) and currency markets (such as the EUR/USD forex pair).
Typically, derivatives require a more advanced form of trading. They include speculating, hedging, and trading. When used correctly, they can supply benefits to the user. However, there are times that the derivatives can be destructive to individual traders as well as large financial institutions. An example of derivatives that were flawed in their construction and destructive in their nature are the infamous mortgage-backed securities (MBS) that brought on the subprime mortgage meltdown of 2007 and 2008.
Types of Derivatives Markets
There are several general derivatives markets, each containing thousands of individual derivatives which can be traded. Here are the main ones day traders use:
- Contract For Difference (CFD) Markets
- Futures Markets
- Options Markets
Contract for Difference (CFD)
The contract for difference (CFD) markets are offered by various brokers, and therefore may differ from one broker to another. Typically they are simple instruments though, labeled with a similar name to the underlying.
A CFD is like a "side bet" on another market.
With most CFD markets (check with your broker), if you believe the underlying asset will rise, you buy the CFD. If you believe the underlying asset will decline in value, then you sell or short the CFD. Your profit or loss is the difference between the prices you enter and exit the trade at.
CFD trading is defined as ‘the buying and selling of CFDs’, with ‘CFD’ meaning ‘contract for difference’. CFDs are a derivative product because they enable you to speculate on financial markets such as shares, forex, indices, and commodities without having to take ownership of the underlying assets.
Instead, when you trade a CFD, you are agreeing to exchange the difference in the price of an asset from the point at which the contract is opened to when it is closed. One of the main benefits of CFD trading is that you can speculate on price movements in either direction, with the profit or loss you make depends on the extent to which your forecast is correct.
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Short and long CFD trading explained
CFD trading enables you to speculate on price movements in either direction. So while you can mimic a traditional trade that profits as a market rise in price, you can also open a CFD position that will profit as the underlying market decreases in price. This is referred to as selling or ‘going short’, as opposed to buying or ‘going long’.
If you think Apple shares are going to fall in price, for example, you could sell a share CFD on the company. You’ll still exchange the difference in price between when your position is opened and when it is closed but will earn a profit if the shares drop in price and a loss if they increase in price.
With both long and short trades, profits and losses will be realized once the position is closed.
Leverage in CFD trading explained
CFD trading is leveraged, which means you can gain exposure to a large position without having to commit the full cost at the outset. Say you wanted to open a position equivalent to 500 Apple shares. With a standard trade, that would mean paying the full cost of the shares upfront. With a contract for difference, on the other hand, you might only have to put up 5% of the cost.
While leverage enables you to spread your capital further, it is important to keep in mind that your profit or loss will still be calculated on the full size of your position. In our example, that would be the difference in the price of 500 Apple shares from the point you opened the trade to the point you closed it. That means both profits and losses can be hugely magnified compared to your outlay, and that losses can exceed deposits. For this reason, it is important to pay attention to the leverage ratio and make sure that you are trading within your means.
Leveraged trading is sometimes referred to as ‘trading on margin’ because the funds required to open and maintain a position – the ‘margin’ – represent only a fraction of its total size.
When trading CFDs, there are two types of margin. A deposit margin is required to open a position, while a maintenance margin may be required if your trade gets close to incurring losses that the deposit margin – and any additional funds in your account – will not cover. If this happens, you may get a margin call from your provider asking you to top up the funds in your account. If you don’t add sufficient funds, the position may be closed and any losses incurred will be realised.
Hedging with CFDs explained
CFDs can also be used to hedge against losses in an existing portfolio.
For example, if you believed that some ABC Limited shares in your portfolio could suffer a short-term dip in value as a result of a disappointing earnings report, you could offset some of the potential loss by going short on the market through a CFD trade. If you did decide to hedge your risk in this way, any drop in the value of the ABC Limited shares in your portfolio would be offset by a gain in your short CFD trade.
Many day traders trade the futures market. This is because there are many different types of futures contracts to trade; many of them with significant volume and daily price fluctuations, which is how day traders make money. A futures contract is an agreement between a buyer to exchange money for the underlying, at some future date.
For example, if you buy/sell a crude oil futures contract, you are agreeing to buy/sell a set amount of crude oil at a specific price (the price you place an order at) at some future date. You don't actually need to take delivery of the crude oil, rather you make or lose money based on whether the contract you bought/sold goes up or down in value relative to where you bought/sold it. You can then close out the trade at any time before it expires to lock in your profit or loss.
Options are another popular derivatives market. Options can be very complex or simple, depending on how you choose to trade them. The simplest way to trade options is through buying puts or calls. When you buy a put you are expecting the price of the underlying to fall below the strike price of the option before the option expires. If it does, you make money, if doesn't, then you will lose the value (or some of it) that you paid for the option.
For example, if XYZ stock is trading at $63, but you believe it fall below $60, then you can buy a $60 put option. The put will cost you a specific dollar amount, called the premium. If the stock goes up, you only lose the premium you paid for the put. If the stock price goes down though then your option will increase in value, and you can sell it for more than what you paid for it (premium).
A call option works the same way, except when you buy a call you are expecting the price of the underlying to rise. For example, if you think ZYZY stock, currently trading at $58 will rally above $60, you can buy a call option with a strike price of $60. If the stock price rises, your option will increase in value and you stand to make more than you paid (premium). If the stock drops instead, you only lose the premium you paid for the call option.
Final Word on Derivatives Markets
Depending on a trader's trading style, and their capital requirements, one market may suit one trader more than another. Although one derivative market isn't necessarily better than another. Each market requires different capital amounts to a trade, base on the margin requirement of that market.
Futures are very popular with day traders--day traders only trade within the day and don't hold positions overnight. Options and CFDs are more popular among swing traders--swing traders take trades that last a couple of days to couple weeks.
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