Derivative Instruments: What Are They and How To Trade Them?
The derivatives market is stronger than ever and continues to grow, and derivative instruments are an essential part of it. What are they, and how can you use them to your advantage, make a profit and reduce risk? If you give us a minute of your time, you will get an excellent return on your investment. You will learn all about derivatives, what is derivatives trading, alongside its benefits and risks.
What Are Derivative Financial Instruments?
Derivative financial instruments represent a class of financial instruments, alongside equity (stocks, shares, etc.), debt (bonds, mortgages, etc.), and forex instruments.
While equity and debt have inherent value (albeit market-determined), a financial derivative draws its value from the underlying asset, such as equity.
There are two primary groups of derivative instruments:
- Forward-based products (futures, forward contracts, and swaps)
- Option-based products (puts, calls, caps, floors, and collars)
However, some derivatives transactions combine qualities of both. They are options on futures, optional-purchase mortgage commitments, swaptions, and forward caps.
What Are Derivatives Used For?
Derivatives came about as a way to reduce risks. Some derivative contracts help producers mitigate the risks of rising commodity prices or anticipated shortages.
Stock market derivatives meanwhile enable investors to drop out of a deal to buy/sell shares, should market conditions become unfavorable.
Then, the role of derivatives in banking is vital, as banks practically dominate the market. They use derivatives to mitigate risk, enlarge and spread portfolios, etc.
While derivatives offer many opportunities to make a profit, their primary purpose is reducing risks.
The Most Common Types of Derivatives
Financial derivatives are a vast area, and there are so many ways to trade. However, most of these derivatives are rare (especially for retail investors).
So, the derivative instruments you will most likely run into are:
This type of derivatives contract is mainly used in commodity trading. A futures contract represents an agreement to buy or sell a particular commodity, asset, or security with a predetermined date and price.
When we compare futures and options, the latter give the investor the right, rather than the obligation to buy or sell an asset. This type of derivative security is used for shares, so they are often called stock derivatives. This financial contract also includes an expiration date and a predetermined price.
Forward contracts form the base of the derivatives market. Like futures, they also imply a certain commodity switching hands on a specific date and for a specific price. However, these derivative instruments are private and highly customizable. Unlike futures, which have standardized terms and are traded on the market, futures are traded over the counter (OTC) in direct derivatives contracts between two parties.
Like forwards, swaps are also highly customized types of derivative securities and are traded OTC. They represent an agreement between two parties to swap their liabilities or cash flows based on separate financial instruments (interest rates, loans, bonds, etc.)
Can you trade all these derivatives?
The last two types of financial derivatives are typically used by organizations like banking institutions, large companies, and asset management firms. Small private investors most often trade futures and options.
Derivative Instruments — How Can You Trade Them
There are two main financial derivative types of trading available – public (exchange) and private (OTC). Derivatives traders come in four types:
- Hedgers. Hedging is a way of mitigating risks. This type of derivatives trader invests in financial markets to reduce the risk of excessive and unexpected price volatility in exchange markets.
- Speculators. Speculation is quite different from hedging and is the most widespread financial activity in the derivative securities market. Speculators, therefore, bet on the future value of certain assets, which results in buying and selling derivatives accordingly.
- Arbitrageurs. These traders profit from the price instability on the market.
- Margin traders. They buy and sell the collateral the investor has deposited to cover the risk of a certain investment.
You can choose the market and the derivative instruments according to your preferences and abilities, and opening an account on trading platforms is pretty straightforward. Note, however, that depending on the derivative instrument you decide to trade, options being the most prominent example, you might need to be cleared by a brokerage company first.
This involves completing a questionnaire about your knowledge, and experience in trading derivatives, derivatives assets, and strategy. After careful consideration, the brokerage company will assign you an options trading level 1 to 5. It will determine the types of trade you can do.
Learn more: Tips for options trading
Derivative Instruments Trading — Pros & Cons
Like any financial instrument, derivatives in finance come with their own set of pros and cons. If you are a new trader, these are the things you should keep in mind:
Pros of derivatives trading:
- They have locked prices
- They can protect your already active investment
- They can help you diversify your portfolio
- They are leveraged — you get a large amount of value in the underlying asset for just a fraction of the price.
Cons of derivatives trading:
- They can be hard to understand for beginners
- Sensitive to price fluctuations and outside factors like interest rates
- They can be hard to value since their value is linked to the underlying asset.
FAQs on Derivative Instruments
What are financial derivatives?
A financial derivative is a good way to make a profit and protect your existing investment. In short, they are contracts that are based on an underlying asset. In turn, their value is also derived from the value of that asset. It can be equity, commodity, market index, or reference rate. The most common types of financial derivatives are:
What is a derivative contract?
Derivatives contracts are bilateral agreements that draw their value from an underlying asset. Depending on the type of contract, they can be traded on an exchange or over the counter.
What are derivatives markets?
Derivatives markets are places or systems where participants can trade derivative financial instruments. Most products have defined markets, including markets for currency derivatives, bond derivatives, debt derivatives, etc.
What are derivative instruments examples?
The most common examples of financial derivatives include forward contracts, futures contracts, options contracts, and credit default swaps.
What are the main benefits and risks of derivatives?
The main benefit of derivatives is the relatively low initial investment. If we compare options vs. stocks, for example, the former give you the right, rather than the obligation to complete a transaction, and you only risk the premium you’ve paid. The risks come from the fact that derivative instruments are influenced by the underlying asset’s price and the market’s state.