What Is Derivative in Trading & How It’s Beneficial

What is Derivative?

A derivative is a financial contract whose value is derived from an underlying asset, index, or benchmark. This contract then allows traders to speculate on or hedge against future price movements without directly owning the underlying asset.

Understanding Derivatives in Trading

The value of a derivative can depend on stocks, commodities, indices, or currencies. In investing, derivatives act as a versatile tool that allows investors to take positions on the future price movements of these assets. Essentially, enabling two parties to trade risks and returns tied to an underlying asset. The three key features of derivatives in trading are leverage, margin trading, and liquidity.

• Leverage: Often, derivatives only require a fraction of the underlying asset’s value as collateral which then allows traders to control larger positions with a smaller capital. However, this is at the risk of higher potential gains and losses.

•  Margin Trading: Derivative trading often involves using margin accounts for traders to borrow funds to enter positions. This makes the trade more flexible but also carries the risk of margin calls if the market moves unfavorably.

• Liquidity: Most derivatives traded on exchanges offer high liquidity that allows traders to enter and exit positions quickly even in volatile markets.

  
  

Most traders trade derivatives to profit from anticipated or speculated price changes in the underlying assets. For example, a trader may buy a call option on a stock they predict will rise. This then allows the trader to benefit from the price increase without purchasing the stock.

Companies and investors, on the other hand, may use derivatives to mitigate risks. For instance, an exporter may use currency futures to hedge against adverse exchange rate movements. Derivatives create access to various markets, such as commodities, foreign currencies, and indices, that may not always be accessible to all investors.

Types of Derivatives in Trading

1. Swaps

Swaps are contracts that allow two parties to form an agreement to exchange cash flows or financial instruments over a specified period. The most common forms of swaps are interest rate swaps and currency swaps. Interest rate swaps involve the exchange of fixed interest rate payments for floating rate payments.

Thus helping parties manage exposure to fluctuations in interest rates.  

On the other hand, currency swaps involve exchanging principal and interest payments in different currencies, allowing parties to hedge against foreign exchange risks.

2. Forwards

Forwards are customized contracts between two parties to buy or sell an asset at a predetermined price on a specific future date. Forwards are traded over-the-counter (OTC) and are not standardized. The key characteristics of forwards are this customization to the needs of the parties involved as well as its settlement where it is typically settled at maturity with the actual delivery of the asset or cash settlement. Forwards are most commonly used in commodities and foreign exchange markets to hedge against price volatility.

3. CFD Trading

Contracts for difference (CFD) are financial derivatives that enable traders to speculate and predict price movements of assets without owning the underlying asset. They function by opening a position in an asset's price and leveraging it.

A trader will enter a contract with a broker to exchange the difference in the asset’s price from when the position is opened to when it is closed and control more prominent positions with a smaller initial investment. CFDs are flexible and provide potential for profit in both rising and falling markets. Thus making it popular for trading assets such as stocks, indices, commodities, and currencies.

4. Futures Contract

Futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a specific date. Unlike forwards, futures are traded on exchanges and have standardized terms. These standardized terms involve quantity, quality, and delivery. Traders must also deposit and initial margin and maintain a maintenance margin to manage credit risks. Futures are most commonly used in commodities markets such as oil, gold, and agricultural products as well as financial markets for indices and interest rates.

 5. Options Contract

Option contracts provide the buyer right but not the obligation to buy (call option) or sell (put option) an asset at a predetermined price before or on a specific expiration date. Options are versatile instruments used for hedging, income generation, and speculative purposes across various markets, including equities, commodities, and currencies.

6. Commodity Derivatives

Commodity derivatives are contracts that derive their value from underlying physical commodities such as metals, energy products, and agricultural goods. The common instruments of this contract are commodity futures and commodity options. Commodity futures are standardized contracts to buy or sell a specific quantity of a commodity at a future date while commodity options are options giving the holder the right to buy or sell a commodity futures contract.

Ultimately, no matter the contract, derivatives are an important tool for producers, consumers, and investors to manage price risk associated with commodity markets. It is crucial to understand how the various derivatives function in order to effectively manage risk and capitalize on market opportunities.

Derivatives Trading Example

A farmer is concerned about potential price drops during harvest season. Thus, in order to secure a favorable price, he enters a wheat futures contract to sell at a fixed price that is favorable to him in three months. If the wheat prices do indeed drop during the harvest season, the farmer avoids a loss as the futures contract ensures that his sale remains at a favorable price. Therefore, the derivatives act as a safeguard against adverse market movements.

How to Trade Derivatives with Straits Financial?

At Straits Financial, we provide a seamless and secure platform for derivatives trading that caters to novice and experienced traders. Consult us on the best fit for your investment needs, our team of experts is here to help and provide the best solutions. 

Straits Financial offers a wide range of derivatives products across all asset classes, reliable support, and the most secure and transparent transactions to ensure our clients' smooth trading journey. Whether you are looking to hedge your risk or explore new trading opportunities, Straits Financial provides the tools and expertise needed to thrive in the derivatives market.