Derivatives 101: The Different Kinds of Derivatives

Derivatives 101: The Different Kinds of Derivatives

Aside from common stocks (and preferred stocks), currencies, commodities, and real estate, you can also trade derivatives. But what are these so-called derivatives?

Derivatives are powerful, profitable, and rewarding. However, they’re not as simple as other assets. The derivative markets aren’t really similar to other financial markets.

Derivatives trade written on a key

 

Let’s see what derivatives are first, and then we’ll give you a tour on its different kinds. Hop in!

What are Derivatives?

It’s not uncommon to hear the phrases “financial derivatives” and “derivatives market” on financial news. That’s because there’s so much to get from derivatives. In fact, more and more traders are becoming more interested in derivatives.

While there are criticisms over the nature of derivatives, there’s no denying that many have earned tons of cash from this joint. And if you want to be one these people, you got to know first what derivatives are.

A derivative contract is basically a mere contract. Simply put, this contract lets the buyer and the seller to agree on the future price of an underlying asset. It’s worth noting that the parties also agree on a specified date.

What’s important for this contract is the price change of the underlying asset. The price today should be higher or lower than the set price, or the contract will be useless.

The parties “derive” the value of the contract based on the fluctuation of the price in the underlying asset.

These days, derivatives markets offer a plethora of options to buyers and sellers. To put it another way, you can buy a derivative contract on almost any asset. Bear in mind, though, that the basis of most derivatives are stocks, bonds, and commodities.

Derivatives have distinctive and defining features that set them apart from other financial assets.

Contract Obligations and Choices

In derivative contracts, the actual trade happens on the determined future date. However, keep in mind that contracts differ in terms of the parties’ rights and obligations to follow through the trade.

Some contracts bind both the buyer and the seller, meaning they’re obligated to execute the trade on the set date.

There are also contracts in which one party has the right to push through the contract but not the obligation. That means that if he thinks it’s in his favor, he will execute the trade. If he doesn’t think so, he can just ignore it.

Expiration Date

Just like any other contracts, derivatives contracts have expiration dates. Once that date arrives, the contract becomes practically worthless.

This feature makes it necessary for the parties involved to make use of the contract before its expiry. Such feature definitively sets contracts apart from other financial tools like stocks and bonds.

Zero-sum Game

When something is a zero-sum game, it means that gains in one party spell losses in the other party. In a derivative contract, the two parties are basically wagering against each other.

If you win, the other party loses. If you lose, the other party wins. This is very different from the stock market in which a stock’s rise benefits everyone owning that stock.

This feature makes it quite risky, given the fact that most derivative traders use leverage to gain more. The combination of high leverage and a zero-sum game makes for a loss-making nightmare if you’re not careful enough.

In spite of that obvious risk, traders still choose derivatives. The reason? Read on.

Why do traders choose derivatives?

Derivatives contracts also pose systemic risk, and anyone could fall for that. Nonetheless, many still choose derivatives as their trading market. Why is that so?

There are many reasons—and good reasons at that. Here are some of them:

Reason 1: They use it for hedging.

Originally, derivatives served as tools for hedging, especially for businesses that rely on commodities. Commodities like oil have volatile prices. This means that businesses relying on commodities are quite unstable. Derivative contracts can provide such businesses a way to be safer from volatility.

Reason 2: They use it to avoid Regulations.

Some institutions cannot invest in any kind of risky securities. Pension funds are one of them. Derivatives, however, give them a chance to remove the risks in securities.

Reason 3: They use it to enable speculation.

Speculators, in spite of the criticisms aimed at them, are quite necessary for the markets to have some liquidity. If hedging is for those with real interest in the underlying asset, speculation is for those who just want to earn something out of price movements.

Reason 4: They use it to lower their trading expenses.

Derivatives are extremely useful if you want to lower the transaction costs you incur. There are certain kinds of derivatives in which you are able to swap one thing for another. Such mechanisms can serve as a way to reduce or even evade huge transaction costs.

Different kinds of derivatives offer distinct advantages. Of course, different traders and investors have different needs. If you want to gain something out of derivatives, you need to know which one will suit your situation best.

Derivatives: Forward Contracts

You may consider forward contracts the simplest form of derivatives. In addition to that, these are the grand-daddy of other derivatives, being the oldest one.

derivatives contracts forwards contracts

A forward contract is simply an agreement to sell an asset on a future date. The involved parties decide the price at the present.

Bear in mind that forward contracts exist between two counterparties. The exchange will not serve as an intermediary for the transaction. It goes without saying that there’s higher counterparty credit risk.

It’s also worth noting that sometimes the contracts need to be reversed before expiring. And when that happens, the specifics of the contract may become unfavorable for the parties. The terms of the contracts are confidential to both the parties.

Derivatives: Futures Contracts

A futures contract is very similar to the forwards. Futures contracts also enable parties to sell assets in the future though the price is set at present.

The difference, though, is that futures are on an exchange. In other words, the exchange serves as an intermediary.

Futures are standard in nature and you or any other party won’t be able to modify them in any way. They have strict formats, sizes, and expirations. They also follow a daily settlement procedure, meaning any gains or losses should be settled the same day. This gets rid of the counterparty credit risks.

Remember that the buyer and seller in a futures contract are entering into an agreement not with each other but with the exchange.

Overall, the parties entering into this kind of derivatives contract have the obligation to follow through the trade.

Derivatives: Options Contracts

Options contracts are very different from the first two derivatives contracts. Forwards and futures bind the two parties to fulfill their duties to the contracts. On the other hand, an options contract binds only one party. The other party is then given the choice whether to push through the contract on a certain date or not.

Once the option has expired, one party has the right to buy or sell but doesn’t have any obligation to do so. Thus, this kind of derivatives contract is called options.

There are two types of options contracts—the call option and the put option. Call options give you the right to buy an asset at a later date without the obligation. Put options, meanwhile, gives you the right to sell something at a later date minus the obligation.

Once similarity that options share with futures is they’re also traded on exchanges.

Derivatives: Swaps

This is perhaps the most complex kind of derivatives in the market. With swaps, participants can exchange their cash flow streams.

One party can switch an unstable cash flow of a more stable one. For example, you can swap a fixed interest rate for a floating one. Additionally, the parties can choose to decide underlying currencies together with the interest rates.

More often, different participants use swaps to cancel out foreign exchange risks. Parties don’t typically trade swaps on an exchange. You can consider them as private contracts between two parties.

Conclusion

Derivatives are very useful instruments that you can use to gain more trading firepower. They provide alternative ways to profit from the market.

Those kinds mentioned above are only the most basic types of derivatives. Combinations of these contracts result to more complex derivatives. One such example is the contract for differences, which we discuss in a separate article.

 

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