Derivatives trading poses a layer of complexity above stocks. However, thanks to the democratising efforts of Robinhood, both derivatives and stock trading have become exceedingly approachable to anyone with internet access and a bank account. Alongside crypto derivatives, futures contracts, swaps, and options, all of them represent securities drawing value from an underlying asset.
What is Derivatives Trading?
A relatively recent financial invention maturing in the 1980s, derivatives markets grew from the simple foundation of commodities such as in the form of coffee and wheat to involving debt and bonds. Although derivatives may seem complex to the uninitiated, derivatives trading has been around from ancient times in one form or another. Essentially, whenever traders placed bets between each other on the price of commodities, this was acting as a trade. Similarly, whenever farmers sold their crops in advance of growing them , you could also speculate on their value.
The above engaged in derivatives trading, meaning an investment that relies on the value of something else — an underlying asset. The word itself — derivative — comes from the Latin term ‘derivare’, which means ‘obtain from’. When you bet on the change in the price of these underlying assets, it means you are entering a contract with another party. This contract is called a derivative.
The underlying assets that form the basis of these contracts can range widely: bonds, (crypto)currencies, shares, student debt, homes, indices, commodities, interest rates, and even derivatives themselves.
Today, derivatives markets allow traders to precisely speculate on when something will fall or rise in price. It bears repeating, derivatives trading is forming a contract between two or more entities based on the value of that something — an underlying asset.
This means that, unlike with stock trading, where you buy a portion of the company, derivatives trading allows you to participate in the market without actually buying the asset itself. Furthermore, derivatives are used by financial institutions and professional traders for hedging, providing a tool to mitigate risk against a secondary position they have taken.
Lastly, derivatives trading can take form as both short and long term, the latter constituting futures.
Example of Derivatives Trading
Let’s start with a simple example.
Imagine your friend, Jake, wanting to sell a brand-new smartphone because he doesn’t like its colour, for $600. However, he will sell it in four months after he gets a better one from his grandfather as a gift. You agree to purchase it from him in four months for $600.
In turn, he agrees he will not sell it to anyone but you, so you sign a contract outlining the deal.
When you both signed the contract, you created a derivative!
The smartphone is the underlying asset, and the contract that draws from that asset is the derivative. This derivative is called a forward contract because it will be executed at a future date.
However, the plot thickens! After two months pass, Jake browses the Internet and notices that a factory chip shortage caused the price of his contracted phone to spike! It is now worth more than $600. In fact, you can buy it for no less than $750.
This means that Jake would get $150 dollars more if he sold his phone to someone else. Luckily for you, you both signed a contract in which Jake obligated himself to sell the phone only to you after a four-month period, of which two months remain.
You realise this and find an interested buyer to sell your side of the contract, for $150. That new buyer will then be able to buy the phone in two months for $600 + $150 for the price of the contract you sold to him. At the same time, Jake is still obligated to sell his phone for $600, after the four-month period ends, to the new contract holder.
In the end, you ended up going from:
- Your initial intention to buy the smartphone in four months for $600.
- To not spending any money at all, but instead receiving $150 by selling your side of the contract.
This is the power of derivative trading!
In this type of contract, the forward contract, Jake was holding a short position, and you were holding a long position. It’s a zero-sum game in which one side, short or long, has to be a winner or a loser. This time, Jake ended up being a loser with his short position because a chip factory mishap spiked the price of his phone. If that didn’t happen, in four months, a new cheaper phone would have come out on the market, making him the winner.
To recap the terminology in derivatives trading:
- The smartphone is the underlying asset.
- The date after four months is the maturity.
- Two sides of the forward contract took short and long positions.
- The price of the smartphone is the strike.
What Kind of Derivatives Contracts Can You Make?
The most common way to trade derivatives is through regulated exchanges, just as cryptocurrency is traded on crypto exchanges. These offer standardised contracts, with the exchange serving as the mediator, thus mitigating risk.
On the other hand, OTC — over-the-counter — derivatives trading is conducted on an unregulated market where contracts are privately set between the parties. As any lawyer would tell you, the power of language is its flexibility. Accordingly, derivatives contracts are crafted to serve different purposes. Here are the most common forms of derivatives contracts:
- Options - the right without obligation to buy or sell a certain asset at a certain price within a certain time span.
- CFDs - contracts for the difference between two parties where they agree to pay the difference in price for an asset between its position when it opened and when it closed.
- Forward contracts - when two parties — buyer and seller — agree to a price at the present moment to trade an asset at a future moment. As the price of the underlying asset shifts, the parties’ profits and losses are finalised on the OTC market.
- Futures contracts - same as forward contracts, except conducted on regulated exchanges with daily settlements of profits/losses.
- Swaps - parties engage in the trade of cash flows, or variables tethered to assets and cash flows: currencies (loan repayments), interest rates (variable vs. fixed interest rate on loans), commodity swaps (usually done by large corporate entities).
Derivatives Trading as Risk Reduction
As you might have inferred from the smartphone example, derivatives trading is very flexible. Therefore, it can be used as a form of hedging — forming a contract, or opening an investment position, to guard against unforeseen losses in the future.
You can look at such hedging as a type of insurance. For example, a fictitious computer manufacturing company, Gpunia, must buy a steady supply of memory chips to stay afloat from the fictitious supplier, the MemChip company. Therefore, Gpunia’s margins can be threatened if the memory chips’ price rises in the future.
To form a type of insurance against this eventuality, Gpunia creates a contract — derivatives trading — with MemChip to ensure a steady supply of memory chips at a guaranteed price during a set period. On the other end of the contract, MemChip has peace of mind knowing that its sales of memory chips are secured for that time period.
Therefore, both Gpunia and the memory chip manufacturer create securities. Gpunia against the potential for memory chip price to spike, and MemChip against the potential for memory chip price to slump. After the set period, the company that loses from the contract is the one that missed out on the spot price of the underlying asset — memory chips.
As you can see from this example, Bitcoin derivatives on the crypto derivatives market would be conducted in a similar manner, each party betting on the price of Bitcoin in the future. Therefore, the key to profitable derivatives trading is to correctly guess the trajectory of the underlying asset. For this purpose, you have a wide variety of tools at your disposal, from Japanese candlestick charts to an RSI (relative strength indicator) indicator.
Margin trading carries a high level of risk to your capital and you should only trade with money you can afford to lose. Margin trading may not be suitable for all traders, so please ensure that you fully understand the risks involved, and seek independent advice if necessary.
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