Derivatives Trading

Updated on April 4, 2024
Article byShrestha Ghosal
Edited byShrestha Ghosal
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Derivatives Trading?

Derivatives trading involves financial contracts or instruments whose value is obtained from an underlying financial asset, including stocks, bonds, commodities, currencies, or market indices. Two or more parties form these contracts, known as derivatives. Investors and traders use them to speculate on price movements, manage risk, and generate profits.

Derivatives Trading

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The derivatives traders do not own the underlying assets. Instead, they bet on the price fluctuations in those assets. Derivatives offer several essential functions in financial markets. This trading enables traders to hedge against adverse price movements and efficiently allocate risk in various industries.

Key Takeaways

  • Derivatives trading is a financial activity that involves creating contracts between two or more parties. These contracts obtain their value from an underlying financial asset.
  • This trading allows traders to generate income by speculating on the underlying asset’s price movements without owning it. They profit from anticipating increase and decrease in asset prices. Moreover, holders may use the contracts for hedging purposes.
  • However, some derivatives may not be liquid, which makes it difficult to buy or sell them at desired prices. Holders may find it challenging to exit their positions or incur increased transaction expenses.

Derivatives Trading Explained

Derivatives trading is a financial activity that revolves around specialized contracts known as derivatives which are formed between two or more parties, and their value is attained from an underlying asset, index, or reference rate. These contracts enable traders and investors to speculate on the underlying asset’s price movements without owning it.

In this trading, traders can profit from anticipating rising and falling asset prices. Additionally, traders often use these contracts for hedging purposes. It allows producers and consumers of commodities to lock in prices and reduce uncertainty. Furthermore, investors may participate in the futures market to profit from price movements by taking positions that they later even out before the contract’s expiration.

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Strategies

Some derivatives trading strategies are:

  • Hedging: Hedging is a risk management strategy where traders use derivatives to balance the potential losses in their underlying investments. For instance, an investor holding a portfolio of stocks might buy put options to protect against a market downturn. This ensures a minimum selling price for their stocks.
  • Speculation: Speculators enter the derivatives market to profit from price movements. They may buy call options if they expect the underlying asset’s price to rise or put options if they anticipate a decline.
  • Arbitrage: Arbitrage helps exploit price differences between related assets or markets. Traders may notice that the same asset is trading at slightly different prices on different exchanges or that the future price of an asset is higher than the spot price. They buy low and sell high to profit from these price discrepancies and eliminate the risks effectively.
  • Options Strategies: Options offer derivatives trading strategies, like straddles, strangles, and covered calls. These strategies allow traders to customize their risk and return profiles.

Types

The types of derivatives trading systems are:

  • Futures Contracts: Futures contracts are standardized agreements to buy or sell an underlying asset at a predetermined price on a specific future date. Traders commonly use these contracts for hedging and speculation.
  • Options Contracts: Options give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a predetermined date. Options are flexible, and traders employ them for various purposes, including hedging portfolios and generating income through covered call writing.
  • Swaps: Swaps are bilateral contracts between two parties to exchange cash flows or assets based on specific criteria. Common types include interest rates, currency, and credit default swaps. They are used for risk management, portfolio optimization, and capital structure adjustments.
  • Forward Contracts: Forward contracts are private agreements between two parties to buy or sell an asset at a future date for a predetermined price. These contracts are customized and suitable for unique, tailor-made transactions. They are commonly used in the foreign exchange market, commodities market, and for certain over-the-counter derivatives.

Examples

Let us look at the following examples to understand this trading:

Example #1

Suppose Amy is an investor with $10,000. She anticipated Apex Ltd.’s stock prices would increase in the next three months. Instead of buying the shares directly, she decided to use derivatives. Amy purchased call options on the company’s stock, which gave her the right to buy 100 shares at the current price of $100 per share. She paid a premium of $500 for the options. Apex Ltd.’s stock prices went up to $120 per share, and Amy exercised her call options to buy 100 shares at $100 each, even though they were trading at $120 in the market. She sold them for a profit of $2,000.

Example #2

On September 28, 2023, Coinbase declared that it had obtained the required regulatory license to offer its users futures trading services. The Bermuda Monetary Authority (BMA) approved expanding the organization’s perpetual futures trading services to non-US retail clients.

The second-largest exchange in the world declared that the futures market alone accounts for nearly 75% of all worldwide crypto trading volume and that tapping into it would substantially increase the exchange’s earnings. The institutions’ spot trading volume and derivatives trading on Coinbase International Exchange comprise more than $5.5 billion. This is another example of derivatives trading.

Benefits

Some derivatives trading system benefits are as follows:

  • Derivatives allow investors and businesses to hedge against adverse price movements in underlying assets. This can protect against financial losses and make it easier to plan for the future by maintaining financial stability.
  • They allow investors to diversify their portfolios by gaining exposure to different asset classes, including commodities, currencies, and interest rates. This diversification may help spread risk and improve overall returns.
  • This trading often requires a smaller initial investment than directly buying or selling the underlying assets. This leverage allows traders to control more significant positions and potentially amplify returns using less capital.
  • The derivatives contracts are highly customizable, allowing participants to set up risk and return profiles for their specific needs. This flexibility makes them suitable for various financial objectives and strategies.

Risks

The derivatives trading risks are:

  • This trading involves margin trading. It implies traders can control a prominent position with relatively little capital. This feature magnifies losses. A slight adverse price movement can result in significant losses and exceed the initial investment.
  • One of the primary derivatives trading risks is that derivatives are sensitive to changes in the prices of their underlying assets or indices. They may incur losses if the market moves against the trader’s position. Market risk can be unpredictable and influenced by various factors, including economic events, geopolitical developments, and unexpected news.
  • In derivatives transactions, traders have a counterparty, which is the entity on the other side of their trade. If the counterparty defaults on their obligations, traders may face losses.
  • Some derivatives may have limited liquidity, making buying or selling them at desired prices challenging. Illiquid markets may increase transaction costs and difficulty exiting positions, especially during market stress.

Derivatives Trading vs Equity Trading

The differences between the two are as follows:

Derivatives Trading

  • In this trading, participants do not own the underlying assets. Instead, they speculate on price movements or use derivatives for risk management.
  • Derivatives enable more accurate risk exposure. Traders can take positions that profit from both rising and falling markets.
  • They frequently offer high leverage, allowing traders to control more significant positions with less capital.
  • This trading provides opportunities to diversify across various asset classes, including stocks, bonds, currencies, and commodities, allowing traders to spread risk more broadly.

Equity Trading

  • Equity traders own a tangible stake in the company. This ownership includes certain shareholder rights, including voting on company decisions and receiving dividends.
  • This trading primarily involves directional bets on individual stocks or market indices. Profits are generally made when the value of the owned shares appreciates over time.
  • In this trading, leverage is generally lower. It implies that equity traders usually have less expanded exposure to market movements.
  • These traders can diversify by investing in various stocks or exchange-traded funds. However, diversification within the equity asset class may be limited.

Frequently Asked Questions (FAQs)

1. What are the regulations for derivatives trading?

This trading is subject to a set of regulations. Regulators, including the U.S. Commodity Futures Trading Commission (CFTC) and the European Securities and Markets Authority (ESMA), enforce the rules in this trading. Additionally, derivatives may be traded on organized exchanges or over-the-counter, with different regulatory requirements applying to each. Furthermore, regulations may vary by country and region.

2. Are derivatives trading illegal?

This trading is not inherently illegal. However, it can be subject to regulations by the financial authorities to ensure market integrity, transparency, and investor protection. Engaging in fraudulent activities or manipulation within the derivatives markets is illegal and may lead to legal consequences.

3. What is ISDA in derivatives trading?

The ISDA, or the International Swaps and Derivatives Association is a globally recognized trade association crucial in this industry. It serves as a framework for standardizing and documenting over-the-counter derivatives transactions. The ISDA publishes legal documents, like the ISDA Master Agreement, which define the terms and conditions governing the derivatives contracts. These documents help establish standardized procedures for this trading, and help reduce legal and operational risks. It also addresses industry issues, promotes market best practices, and supports regulatory and market structure improvements
within the derivatives market.

This article has been a guide to what is Derivatives Trading. We explain its strategies, types, benefits, risks, examples, and comparison with equity trading. You may also find some useful articles here –

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