When you are trading, you always want what’s beneficial to you and especially what can help you gain more profit. With proper research, there are a lot of available tools and solutions for that. You just need to find the one that’s the best fitting for you and your style.
In trading, you can encounter many kinds of things that you may not have known before you got into the industry. Most people would have heard about funds, stocks, and bonds, but most likely not about derivatives.
What Is a Derivative?
If you’re unfamiliar with finance, you might ask, what are derivatives in finance? Generally speaking, a derivative is a financial security that takes its value from an underlying asset. It is also a contract or agreement between two or more parties, and its price fluctuates according to the asset value from which it is derived.
Underlying assets can be:
- Commodities
- Shares
- Bonds
- Currencies
- Stock indices
- Any other assets
Why Use Derivatives?
Financial derivatives are used for three primary purposes:
Position Hedging. This is one of the most common uses of derivatives. Hedging positions are done to minimize the risks of unfavorable fluctuations in the price of the assets.
Speculations of Future Prices. In relation to hedging, derivatives are also used to benefit from the movements of prices of the underlying assets. It allows you to profit from price decreases or short-selling and increases or long-selling.
Leverage a Position. For traders, this is the most critical purpose of derivatives — leveraging. Leverage lets traders open a position just by paying a percentage of its cost. Using leverage like this would increase your possible profits without increasing your needed capital. However, it’s important to note that it can also increase potential losses if the market moves against you.
Trading Derivatives
The derivative market is a huge market due to a large number of available derivatives for assets like currencies, stocks, and commodities. There are two ways to sell or trade derivatives: over the counter or on an exchange.
OTC
Over-the-counter (OTC) derivatives are contracts privately made between parties in an unsupervised venue, without an intermediary. This type of trade constitutes a larger portion of the derivatives market. However, it has a counterparty risk, since it is unregulated, and one of the parties might default.
Exchange
Exchange-traded derivatives are standardized contracts, and it’s not exposed to any counterparty risk since the clearinghouses act as intermediaries. Derivatives traded in this manner are more heavily regulated.
Different Types of Financial Derivatives
There are many types of financial derivatives available for traders. The more popular and main ones include the following.
Swaps
Swaps allow counterparties to exchange cash flows or other various investment variables. It offers investors a chance to exchange assets or debts for another with the same value, managing to reduce the risks for the parties involved.
Swaps occur many times and also have many types, including:
- Interest rate swaps
- Currency
- Commodity
Futures
A futures contract is an agreement between two or more parties to purchase and deliver an asset at a future date and price both parties agreed upon. This protects buyers from any extreme changes in the costs of the assets. Futures are used in trading commodities most of the time.
Forwards
Forward contracts are like futures. The only difference is that they are only allowed and available for over-the-counter transactions. Buyers and sellers can customize the terms, size, and settlement process for the derivative when creating a forward contract.
Options
An options contract is also like a futures contract: two parties can buy or sell an asset at a predetermined date and at a specific price. However, with an option, the buyer only has the right to buy or sell and has no obligation to fulfill their agreement to buy or sell.
Futures are obligations, while options are only opportunities and are not obligatory.
Advantages and Disadvantages of Derivatives
Derivatives have many significant impacts on financing and to the markets. They are useful tools for investors and businesses. However, it is also essential to consider the disadvantages you might encounter when dealing with derivatives.
Below are some general advantages and disadvantages of derivatives.
| Advantages | Disadvantages |
| Useful in determining prices of underlying assets | Have high risks of causing massive losses |
| Increases efficiency of financial markets | Counterparty risks |
| Helps gain access to unavailable assets or markets | Unreasonable speculations can lead to losses |
| Hedging risks exposure |
Why Invest in Derivatives?
Though derivatives have their downsides, they are mostly overpowered by their benefits. Derivatives are useful if you want to make the most out of your portfolio. It would be possible to manage and decrease risks that investments may bring, and you can take advantage of the fluctuating prices of the underlying assets.
With derivatives, achieving your financial goals can be more convenient. You can also protect your portfolio from any potential decrease in your stock values.
