What Are Derivatives and How to Trade Them – R Blog
There are lots of instrumens in the financial market. Today’s article is devoted to some least popular of them called derivatives: what they are, what types and differences exist, what the advantages and drawbacks are, and how they are used in trading.
A derivative is a financial instrument whose price depends on the base asset and is basically derived from it. This is a type of contract by which two parties agree on giving the asset to one the other under certain conditions, such as the time and price.
Example: today companies A and B sign an agreement on supply of certain goods in a month at 100 USD each item. As a result, no matter how the price of the good changes, the seller must supply it to the buyer exactly in a month’s time and at 100 USD per item.
- Futures is an agreement between the buyer and the seller by which the latter supplies the former with a base asset in the future while the difference between the price of the contract and the future price of the base asset will be paid off by one of the parties.
- Swap means exchange of financial instruments for a short time, after which the instruments go back to their initial owners.
- Forward is a futures with extra supply conditions.
- Option is a non-obligatory agreement between the seller and the buyer that can be cancelled in the future.
- CFD is a contract between a trader and a broker for paying off the difference between the current price of the asset (valid for the moment of signing the contract) and its future price (valid for the time of contract expiry).
From this list, futures, options, and CFDs step forward: unlike forwards and swaps, their behaviour is easier to forecast without special knowledge.
- Hedgers are market players who try to insure their trades by using different instruments simultaneously. Buying one instrument, a hedger can sell another one that correlates with the first one so that if the first trade loses, the second one will cover up for the loss.
- Speculators are market participants who make money on changes in asset prices. They are not interested in the good supplied in the end, they just care for making money fast on the price difference. They never invest in medium and long-term contracts, having their positions open for normally no more than a couple of days.
- Arbitrageurs are market players who usually make money in correlation of various instruments and assets. They have impressive experience, are ready for serious risks, and have high-tech equipment, high-speed mobile and Internet connection. Arbitrary trades are opened and closed in split seconds.
- Marginal traders are those who use leverage for trading.
- Hedging risks
- Higher chances for speculations
- Profits made even on cheap assets
- Higher return on shares, bonds, etc. compared to normal instruments.
- Possible negative influence of leverage in the balance in case of a loss
- High risks emerging from drastic changes in base asset prices
- Time limits
- Low legal protection because such trades classify as bets
- Short-term investing only.
Trading derivatives, one has to take account of the current market situation, and in case of agricultural produce, climat changes also matter.
To understand the market situation, using computer, technical, candlestick, and fundamental analyses. Keep in mind the peculiarities of derivatives, both advantages and disadvantages.