Derivatives trading explained
Derivatives trading has opened up a world of markets for traders since its birth in the 1980s. But what is derivatives trading and how can you get started?
What's on this page?
Derivative markets serve important roles in the global financial system. While derivatives can be complex, they represent the modern day versions of practices that have been around for thousands of years, when individuals would place bets with one another or farmers would agree to sell their crops in advance as a form of insurance.
For individual traders, derivatives trading has opened up a wide array of markets for them, allowing them to speculate when the price of something will rise or fall. However, traders must fully understand derivatives markets before they can trade them, as well as the different types of derivatives and derivative products that are available.
Let’s have a look at what derivatives trading is all about.
What is derivative trading and the derivatives market?
‘A derivative is an investment that depends on the value of something else,’ – Collins English Dictionary.
A derivative is a contract between two or more parties that is based on an underlying financial asset (or set of assets). Derivatives are used by traders to speculate on the future price movements of an underlying asset, without having to purchase the actual asset itself, in the hope of booking a profit. Traders or businesses also use derivatives for hedging purposes, in order to mitigate risk against another position they have taken in the market.
Find out more about short-selling, or learn how you can start trading online in the UK
How can you trade derivatives
Derivatives can be traded in two distinct ways. The first is over-the-counter (OTC) derivatives, that see the terms of the contract privately negotiated between the parties involved (a non-standardised contract) in an unregulated market.
The second way to trade derivatives is through a regulated exchange that offers standardised contracts. This provides the benefit of having the exchange act as an intermediary, helping traders avoid the counterparty risk that comes with unregulated OTC contracts.
There are many derivative products, all with significant differences that are important for traders to understand. Below you can find the 2 most widely used derivatives used by traders:
- CFDs (contracts for difference): CFDs are an agreement between two parties to pay the difference in the price of an asset between the time a position is opened and when it is closed
- Options: options give traders the right (but not the obligation) to purchase or sell an asset at a certain price within a certain timeframe
You can learn more about options and how they work here.
Types of derivatives
There are various types of derivatives that can be traded. These all have unique characteristics that seperate them from one another, and are used by traders for different reasons. Forward and futures contracts are both used to speculate and bet on the future price movements of an asset, or as a hedging mechanism. Options allow traders to hedge against potential price declines, while swaps are used as a way to hedge against risks surrounding debt, foreign exchange movements and fluctuations in commodity prices.
Below is a breakdown of the main types of derivatives:
- Forward contracts: a forward contract involves a buyer and seller. The two agree to trade an asset at a future date, but at a price that is agreed today. The contract is settled on the agreed future date, when the buyer pays for (and in some cases, receives) the asset from the seller at the agreed price, and the profits and losses are realised based on the movement in price of the underlying asset between the start date and end date of the contract. These are traded OTC, with the terms privately agreed between the parties involved.
- Futures contracts: futures contracts evolved out of forward contracts and therefore carry many of the same characteristics. The unique aspects of futures contracts are that they are standardised and traded on exchanges, and are subject to a daily settlement procedure. This means the parties in the contract settle daily over an agreed time period, with the party that has suffered losses paying the other party that has made a profit on a daily basis.
- Options contracts: options give one party the right (but not the obligation) to purchase or sell an asset to the other at a future date at an agreed price. If the contract gives the option for one party to sell an asset it is called a put option. If it gives the option for one party to buy an asset it is called a call option.
- Swaps: swaps are a completely different form of derivative that involves two parties exchanging one another’s cash flow, or a variable attached with various assets. There are different types of swaps, some of the most common of which are listed below:
|Interest rate swaps||Interest rate swaps see one party that has a loan carrying a variable interest rate with another party that has a loan carrying a fixed interest rate. A party may have a variable rate on one loan but the rest of their liabilities may be subject to a fixed rate, encouraging them to swap their variable rate loan for a fixed rate that matches the rest of their debt.
This works the other way around too, with a party looking to swap their fixed-rate loan for a variable rate that aligns it with the rest of their liabilities. There are versions that allow parties the right, but not the obligation, to enter into a swap at an agreed date.
|Currency swaps||Currency swaps involves two parties that are making loan repayments in different currencies. One party agrees to pay the other’s loan repayments in one currency in return for the other party paying their loan repayments in another currency.|
|Commodity swaps||Commodity swaps tend to be used by large corporations or financial institutions rather than individual investors. This typically involves a company that produces or trades in commodities (mostly oil, but also metals and others) agreeing to sell a certain volume of their production to a buyer at a pre-agreed price over a pre-determined period of time.
Producers guarantee a price for their output to hedge against the risks of spot commodity prices declining, and buyers guarantee a price to hedge against the risks of spot prices rising.
Derivatives trading example: hedging
Hedging is used as a form of insurance. As an example, fictitious baking company Baker Corp purchases and consumes a large amount of flour in order to create its products. However, the company is concerned that its margins will be squeezed if the price of flour rises in the future. Baker Corp therefore decides to enter into a contract with a supplier of flour, agreeing to purchase ten sacks of flour in six months’ time for £15 each.
Baker Corp now has a guaranteed supply of flour at a guaranteed price, protecting it from any potential increases in the spot price of flour over the next six months. In turn, the supplier knows it will be able to sell its future production at a set price, mitigating any potential declines in the spot price of flour.
Six months later, at the agreed date, the spot price of flour has soared to £20 per sack. But Baker Corp still pays the agreed price of £15 per sack, saving the £5 per extra per sack it would have had to pay on the spot market. However, the supplier has lost out, missing out on the opportunity to sell those sacks of flour on the spot market at a higher price.
Learn more with IG’s glossary of trading terms
Derivatives trading and leverage
As well as speculating on the price movement on an asset and hedging a position, traders use derivatives to increase leverage. This allows traders to take a larger position on key markets compared to the capital they must deploy, magnifying the size of both the potential profits and losses that can be made.
For example, traders may use leverage to take a position on a stock at a fraction of the cost of the actual share price of the stock.
Read more about the impact of leverage on your trading
The more volatile a market is, the more magnified the returns traders receive from trading derivatives as the price of the underlying asset moves more dramatically. Therefore, higher volatility means the value and cost of both puts and calls increase. Traders use the likes of the Chicago Board Options Exchange Volatility Index (VIX) to monitor how volatile certain financial markets are, in this case the S&P 500.
Round-up: derivatives markets
Derivatives have become popular because they are based on the monetary value of an asset rather than the tangible asset itself, allowing businesses or individuals to trade in the likes of stocks, currencies, and commodities without having to actually buy them. This allows derivatives trading to centre on and be settled in cash, without the actual asset having to be delivered.
Derivatives markets also allow traders to utilise leverage, allowing them to take a much more significant position compared to the amount of capital they must deploy, maximising the potential profits, as well as the losses.
For businesses, derivatives play a vital role in the financial system by acting as a form of insurance through the hedging process, allowing them to avoid negative price movements and mitigate losses, regardless of which way prices move.
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.