What are derivatives?

Derivatives are financial instruments whose value is derived from the price of an underlying asset. This means that the price of a derivative is directly linked to the price fluctuations of another asset such as forex, shares, indices, bonds, or commodities. Traders often use derivatives to speculate on future price movements of these assets, allowing them to profit from both rising and falling markets without having to own the asset itself.

Since derivatives don’t involve the physical exchange of assets, they are typically structured as contracts between two parties. These contracts can be traded either over-the-counter (OTC) or on stock exchanges. The versatility of derivatives allows traders to engage in a wide range of underlying assets, making them a popular tool in the financial markets.

What are examples of derivatives?

There are numerous types of derivative products available to traders. One of the most popular examples is Contracts for Difference (CFDs). When you trade CFDs, you enter into a contract to exchange the difference in the price of an asset from the time your position is opened to when it is closed. As a derivative, CFDs do not involve taking ownership of the underlying asset; instead, you speculate on its price movement.

Other common types of derivatives include:

• Options: These give the holder the right, but not the obligation, to buy or sell an asset at a predetermined price within a specified time frame.
• Forward Contracts: Customized contracts between two parties to buy or sell an asset at a specified future date for a price agreed upon today.
• Futures Contracts: Standardized contracts traded on exchanges to buy or sell an asset at a future date and price.

What are the pros of derivatives?

Derivatives offer several advantages to traders, making them a valuable tool in the financial markets:

• Hedging: One of the primary uses of derivatives is to hedge against potential losses in other positions. This is because derivatives provide greater flexibility compared to directly trading the underlying asset.
• Speculation on Falling Markets: Unlike traditional investing where you buy an asset hoping it increases in value (long position), derivatives allow you to speculate on assets that are expected to decrease in value (short position).
• Leverage: Some derivative products are traded on margin, meaning you only need to deposit a fraction of the full value of the position. This can amplify your returns if the trade is successful, as profits are calculated based on the full value of the trade.

What are the cons of derivatives?

While derivatives offer significant benefits, they also come with risks and drawbacks:

• Market Volatility: Derivatives are sometimes criticized for adding to market volatility. Speculators can cause drastic price swings, leading to speculative bubbles where the value of an asset is driven above its intrinsic worth. When these bubbles burst, they can have devastating effects on markets and economies, as seen during the 2008 financial crisis.
• Amplified Losses: The leverage provided by derivatives can also amplify losses. If a trade goes against you, the losses are calculated based on the full value of the position, not just the margin you deposited. This makes it crucial to thoroughly assess the potential downsides of a trade.

How can you build your trading knowledge?

To successfully trade derivatives, it is essential to build a solid foundation of trading knowledge. Here are some steps to help you get started:

• Education: Invest time in learning about different types of derivatives, how they work, and their associated risks. There are numerous online courses, books, and tutorials available for beginners.
• Practice: Use demo accounts offered by many brokers to practice trading derivatives without risking real money. This will help you gain experience and develop your trading strategies.
• Stay Informed: Keep up-to-date with market news and trends. Understanding the factors that influence the prices of underlying assets is crucial for making informed trading decisions.
• Risk Management: Develop a risk management plan to protect your investments. This includes setting stop-loss orders, diversifying your portfolio, and not risking more than you can afford to lose.

By taking the time to educate yourself and practice responsible trading, you can navigate the complexities of derivatives and potentially benefit from their advantages while minimizing the associated risks.