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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.
Importantly, derivatives allow traders to take both long and short positions on an asset such as a stock, letting them bet whether a share price will rise or fall in the future.
How to 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 is a selection of some of the 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