What is a derivative?
A derivative is a contract between two or more parties that derives its value from the price of an underlying asset, like a commodity. Derivatives are often used as a means to speculate on the underlying’s future price movements, whether up or down, without having to buy the asset itself.
Types of derivatives
There are various types of derivatives. These all have unique characteristics and are used for different reasons. However, derivatives like options and futures contracts can be difficult to trade as they often require large capital outlays or accounts with brokers that buy and sell on your behalf.
Both spread bets and CFDs are also a form of derivative as they track the price of an underlying market.
For example, you can take a position on a futures contract listed on an exchange without buying or selling the actual contract. Rather, you’d use a spread bet or CFD to predict whether the future’s price will rise or fall, based on market conditions. If you think the price will rise, you’d buy (go long) whereas if you think it’d fall, you sell (go short).
While this means you can make a profit or a loss, whatever the market’s doing – based on whether you predicted its movements correctly or not – this form of trading isn’t without risk. Short-selling in particular can bring significant profits or losses, as there’s no limit to how high a market’s price can rise.
Both spread bets and CFDs are leverage forms of trading, meaning that you’ll put up a small initial deposit (called margin) to open a larger trade. This is a small percentage of the total value of your position. However, both profits and losses are calculated based on the full position size, not your margin amount, which means both could significantly outweigh your initial deposit.
Spread betting is a popular derivative product you can use to speculate on financial assets – such as options, spot trading or futures markets – without taking ownership of the asset. When you spread bet, you’ll be putting up a certain amount of capital per point of movement in the underlying market.
There are a few reasons this form of derivatives are used by so many. Spread betting is completely tax-free and commission-free,1 so all of your upfront capital (minus the spread) is going into the size of your trade, not into fees. Also, because spread bets are not traded in standardised units (with the exception of forex lots), you’ve got greater control of your bet size, so you can trade the exact amount you feel comfortable with.
However, they do have risks associated with trading them, as we’ve covered above.
When you trade CFDs, you’re entering into a contract for difference, which is an agreement to exchange the difference between the opening and closing price of your position.
Like spread bets, CFD trades enable you to speculate on the price of an asset by going long (buying) or going short (selling). You can trade on the spot, as well as options and futures prices with CFDs.
CFDs are also free from stamp duty in the UK, plus losses can be offset against profits for tax purposes.1 However, just like spread bets, there are risks associated with trading CFDs, as we’ve covered above.
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. These are traded OTC, with the terms privately agreed between the parties involved. Because these are OTC, forwards incur counterparty risk.
Futures contracts evolved out of forward contracts (see above) and therefore carry many of the same characteristics. The unique aspects of futures contracts are that they are standardised and traded on exchanges. The exchanges guarantee payment, so counterparty risk is lessened. You can trade on futures markets with us using spread bets and CFDs.
Futures are also leveraged, so it’s important to remember that your profit or loss will be determined by the total size of your position, not just the margin used to open it. This means there is an inherent risk that you could make a loss (or a profit) that could far outweigh your initial capital outlay.
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. You can trade on options prices with us using spread bets and CFDs.
Options are leveraged products much like CFDs and spread bets; they allow you to speculate on the movement of a market without owning the underlying asset. This means profits can be magnified – as can your losses, if you’re selling options. When buying call options as spread bets or CFDs with us, you’ll never risk more than your initial payment when buying, just like trading an actual option, but when selling call or put options your risk is potentially unlimited (although your account balance will never fall below zero).2
What is derivatives trading?
Derivatives trading is when you buy or sell a derivative contract for the purposes of speculation. Because a derivative contract ‘derives’ its value from an underlying market, they enable you to trade on the price movements of that market without you needing to purchase the asset itself – like physical gold. You’d do this in the hope of booking a profit.
Derivatives can be traded over the counter (OTC) or on-exchange:
- Over the counter: the terms of the contract are privately negotiated between the parties involved (a non-standardised contract) in an unregulated market. The downside risk is that one party to the contract may not uphold their end. This is known as counterparty risk
- On-exchange: another way to trade derivatives is through a regulated exchange that offers standardised contracts. These are called exchange traded products (or ETPs) and they provide the benefit of having the exchange act as an intermediary. Because the exchange guarantees payment, counterparty risk is vastly reduced
When trading with us, you’ll be taking a position on ETPs using spread bets and CFDs. This means that instead of dealing on exchanges – which can be difficult and costly – you’ll be speculating on price movements exclusively.
What is the derivatives market?
The derivatives market is not a single, physical place. Instead, it consists of all OTC and on-exchange financial instruments that derive their worth from an underlying asset.
The derivatives market plays an important role in the global financial system. Well-known exchanges listing derivatives include:
- The Chicago Mercantile Exchange (CME), which is one of the world’s oldest exchanges and trades derivatives like futures and options linked to commodities and sectors, most famously the agricultural sector and soft commodities
- The Intercontinental Exchange (ICE), which trades derivatives linked to foreign exchange, commodities and more
- The ICE Futures Europe exchange, formerly known as the London International Financial Futures and Options Exchange (LIFFE), which is one of the foremost exchanges in the UK and trades options and futures, most notably on Brent Crude oil
Physical delivery and cash-settled derivatives
Although no asset is bought or sold when a derivative contract is opened, many derivatives may require the physical delivery of the underlying at a specified price on a future date.
Whether the contracts are settled with physical delivery or by cash payments from one party to another depends on the terms of the contract.
- Cash settled derivatives – this is a type of agreement in which the physical underlying asset is never involved in the transaction. Instead, the contract is settled with a monetary amount which represents the value of that underlying (for example, for current price of a gold ingot). All derivatives traded with us are cash-settled
- Physical delivery derivatives – this contract is an agreement to exchange the actual underlying, which must be delivered by the one party to the other at the derivative’s expiry date. This can be less convenient for the trader in terms of taking possession of, storing and selling or maintaining the asset, for example if the underlying being traded is livestock, large amounts of precious stones, etc.
Why trade derivatives?
Here are four reasons why you may want to consider trading derivatives:
The beauty of speculation is that you don’t have to take ownership of anything, but can still make a profit (or a loss) on various financial assets, simply by making a prediction on the market direction. You’d either buy or sell derivatives in the hope of your prediction being correct. For example, if you think the FTSE 100 is set to rise over the coming weeks, you could buy CFDs on a FTSE 100 futures contract. If, however, you think the FTSE 100 may depreciate in price, you’d sell (go short) with CFDs.
- Trading rising and falling markets
With derivatives, you can trade both rising and falling markets, meaning you can profit (or make a loss) even in a depressed or volatile economic environment. You’d go ‘long’ if you think the price of an underlying asset will rise; and ‘short’ if you think it’s going to fall. To open a long position, you’d elect to ‘buy’ the market. When going short, you ‘sell’ the market when opening your trade.
- Trading with leverage
You can use derivatives to increase leverage. This enables you to take a position for a fraction of the cost of the position’s total value (for example, using £10 to open a position worth £300). However, be aware that this magnifies the size of both the potential profits and the losses that can be made.
For example, you can use leverage to take a position on an index futures contract at a fraction of the cost of the actual asset. But, trading with leverage increases your risk as you stand to lose more than your margin amount. This is why you take steps to manage your risk.
Traders, investors or businesses can also use derivatives for hedging purposes, which means opening a second position that will become profitable if another of your positions starts to make a loss. In this way, you can mitigate your risk by gaining some profit and limit your losses overall, without having to close your initial position.
For example, a farmer wanting to lock in a price for future crops would agree to sell the crops at a specified price on a set future date. The farmer lessens the uncertainty about future market conditions by ‘hedging his bets’, as the saying goes, so that he can make a profit and limit loss no matter what the market does.
How to trade derivatives with us
You can trade derivatives with us in a number of ways. Whether OTC or on-exchange, derivatives trading requires large capital outlays and a brokerage account – which is why traders rather use a platform like ours. With us, you can trade 17,000+ markets using spread bets and CFDs.
- Spread bets: when spread betting, you’ll stake an amount of capital per point of price change in the underlying market of your choice
- CFDs: when trading contracts for a difference (CFDs), you’ll be exchanging the difference between the opening and closing price of your position
In addition to 12,000+ popular stocks and ETFs from exchanges around the globe, you can also take positions on the prices of exchange-listed options and futures. All our trades are cash-settled. To take a position on a market:
Examples of derivatives trading
Say you want to speculate on the price of the Nasdaq. You’d need to use a type of derivative, in a trading platform, to do this.
After some thought, you decide to use spread bets to take out a longer-term position predicting what the Nasdaq will do in the future – this is called a futures contract.
If you think the Nasdaq exchange is set to rise over the coming weeks, you’d buy a futures contract (also known as going long), but would sell (go short) if you thought the Nasdaq’s price would fall.
Let’s assume you think the Nasdaq will appreciate in price. So, you decide to go long, betting £100 that the exchange’s market price will go up by your futures contract’s expiry date. If the exchange’s price does go up by 5 points, you’ll make a profit of £500 (£100 x 5 points). If the Nasdaq’s price falls by 5 points, you’d make a loss of £500 instead.
Let’s look at an example. You think the price of Brent Crude may go down, so you want to hedge your oil shares with us using CFDs. So, you go short on 10 Brent Crude oil CFD contracts. CFDs are calculated based on the difference between the market price when you open your position vs when you close it,. and a single standard Brent Crude oil contract is equal to $10 per point.
So, for each point the Brent Crude price falls, you’d make $100 ($10 multiplied by 10 contracts). Likewise, for every point that the oil price appreciates, you’d make a $100 loss.
1 Tax laws are subject to change and depend on individual circumstances. Tax law may differ in a jurisdiction other than the UK.
2 Negative balance protection applies to trading-related debt only and is not available to professional traders.
3 Best trading platform as awarded at the ADVFN International Financial Awards and Professional Trader Awards 2021. Best trading app as awarded at the ADVFN International Financial Awards 2021.
4 Based on revenue excluding FX (published financial statements, October 2021).