Investing > Derivatives Trading Explained

Derivatives Trading Explained

Wondering if there’s money to be made on derivatives trading? This guide will walk you through all the basics.

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Updated March 04, 2022

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Are you captivated by the potential gains that can be generated by trading derivatives? 📈

With a proper strategy, trading futures or options can be a great way to hedge against the risks of the ever-fluctuating market.

It’s also a popular means of speculating on (and profiting from) future price movements. 

Derivatives do not require you to purchase the asset itself, nor does this method of trading require you to fund the whole sum of the contract; you can use leverage. For instance, if the deal you struck costs $10,000 and the margin is 10%, you only need to have $1,000 in your account to go through with it, the rest is borrowed from the broker.

Sounds good right? Well, there’s a bit of a catch.

The fact that derivatives trading is highly leveraged and can be unpredictable at times makes it a double edge sword. On one hand, when you only have to invest a thousand to control ten thousand worth of investment, the profits are going to be effectively multiplied by ten. On the other hand, the losses are multiplied as well.

If you’re interested in jumping into this type of trading but are squeamish about the potential risks, use this article as your main resource in the world of derivatives trading. We’ll learn more about what derivatives are, what types of derivatives are the best to trade, and how to trade them safely.

Ready? Set? Let’s go! 🚀

What you’ll learn
  • What are Derivatives?
  • Definition of Derivatives Trading
  • Types of Derivatives
  • Cryptocurrency Derivatives
  • Tips for Trading Derivatives
  • Example of Derivatives Trading
  • Pros and Cons of Derivative Trading
  • The Dangers of Derivatives
  • Conclusion
  • Get Started with a Stock Broker

What are Derivatives? 📚

Derivatives are financial instruments that derive their value from underlying assets. They are typically used to either hedge against the risks of having a long position or to speculate on the value of the underlying asset without necessarily holding it. Recently, large institutional traders started to turn to derivatives again to hedge against falling markets.

Derivatives are best exemplified by the most widespread types — futures and options. These types of contracts represent either the legally binding promise (in case of futures) or a possibility (in case of options) to purchase a specific asset at a specific price before or at the time of the expiration of the contract.

Derivatives are contracts and not classic long-term investment possibilities like shares or bonds. This means more opportunities can be negotiated directly with a broker or a company issuing them. Some can only be obtained that way. Most futures and options, though, can be traded on regulated markets like Nasdaq.

Definition of Derivatives Trading: Diving In 📘

Derivative trading is trading financial instruments without purchasing the underlying assets. Derivatives are contracts to buy or sell an asset — a share, a bond, or a commodity. But as a trader, you don’t necessarily want to make that purchase. For instance, if a trader purchases an oil future, they may not even have the capacity to store the commodity of oil in the first place.

Instead, they can buy or sell the derivative contract itself, making a profit without ever having to sell or buy the underlying asset itself. Derivative trading can be done on exchanges like Chicago Mercantile Exchange via a variety of stock trading apps and online brokerages. You can also trade on OTC markets, which may be a bit more difficult for a novice trader. OTC or over-the-counter markets do not provide public trading. All deals are done between private parties, and often, the details are not made available to the public.

Derivative trading is quite different than holding a long position in the conventional stock in that for many, it can be a zero-sum game. When a trader purchases a futures contract that obliges them to buy a certain amount of assets at $50 and the contract expires at $40, they will incur a loss of $10 per asset. If the price at expiration is higher than $50, then the trader is at a gain.

However, not all futures have to be a zero-sum game with a winner and a loser. For instance, an agricultural corporation may issue derivatives to hedge against a drop in prices. If they sell futures at a strike price of $50 and end up selling the underlying asset when the market price is at $60, the company is at a loss. However, it’s not too damaging for the company as settling for a baseline profit was the initial strategy (meaning, the corporation needed at least $50 per contract to see a profit).

An investment fund that holds a long position in stock may hedge against the risk of the price decreasing by purchasing derivatives.

This way, the profit from a price increase will be smaller due to a lost short bet, but in the event of a price decrease, the loss will be partially countered by the premium received from selling the call option. Purchasing a derivative contract can be a better way to hedge than placing a stop-loss order because it locks in profit for a longer amount of time and is not triggered automatically. 🎚

The thing that attracts a lot of day traders to the derivatives market is the fact that margins on them are a lot lower than with, say, securities. A typical margin required by the broker to purchase securities is around 50%, while derivatives require anywhere between 3% and 12%. This can allow derivatives traders to access significantly more derivatives than stocks — with the same amount of funds.

Trading on a much larger margin can increase the ROI as you keep all the profits made with leveraged funds and only pay the interest on borrowed funds. It can also be very dangerous for your bottom line because unlike with long positions, losses can be potentially unlimited, and you need to cover them when bound by the contract.

What’s a Derivatives Contract? 📜

Derivatives are not traditional trading assets like stocks, bonds, or commodities. They’re contracts to purchase these types of assets and they ultimately work just like any other business contract. The most widespread derivative contracts are options and futures. These types of contracts give the holder the right to either buy or sell a particular asset. In the case of the futures contract, it’s not a right, but an obligation.

So when a trader purchases a call option, they effectively pay for the right to purchase a certain amount of stock at a particular price (called the ‘strike price’) until a specified date. Suppose a stock costs $50 at the moment, and a trader purchases a call option with a strike price of $52, with the premium price of $0.15 per share for a total of 1000 shares.

They’re betting against the seller of the stock and hoping the price of the stock will increase (they think it’s going to increase beyond $52). If it doesn’t increase, all the trader stands to lose is the $150 premium they paid for the call options, which are typically much lower than the share price.

The issuer of the call option contract keeps the $150 premium as a profit. If the price of the stock does rise over $52, they’ll be at a loss because they’re contractually obligated to sell the specified number of shares under the market price. The trader who holds the call option is gaining profit on the deal as long as the increase in price covers the premium they’ve paid for the contract. 💸

Purchasing the underlying asset is not necessary to exit the contract, though. Options, for instance, can simply expire as traders are not contractually obligated to make the purchase on their end, they just have the right to do that. Other ways to exit a contract may be selling it before expiration or purchasing a contract that nullifies the previous one.

If a futures contract does expire when a trader holds it, they’re obligated to make the purchase or the sale, even if it’s at a loss to them. This is why derivatives trading is not suited for beginners, contracts like these have the potential to create unlimited losses.

If a trader enters a contract with the obligation to sell 1000 shares at $20, effectively making a bet that the share will drop in price, and the share price goes up to $60, they’re incurring a loss of $40 per share plus the premium. When the contract expires, the broker will collect the funds from their account to cover the call by purchasing shares at $60 and selling at $20. The loss potential is unlimited because there’s no limit to what price the shares that are the object of the contract can rise. 💹

How Do Derivatives Affect Stock Prices? 📊

The underlying assets affect the price of the derivatives directly and in a predictable manner. But does the derivatives market affect the price of the stock? That’s a question with no clear answer. There’s no direct relation, but in many cases, you can see a correlation in stock prices beginning with the derivatives market, as indicated by the Bundesbank report.

However, the derivatives market is a lot more forward-looking than the spot market, and it can be the case that the price of the stock is going to register faster with the derivatives market. There’s still potential for panic and market manipulation as when the market moves to short a particular stock heavily, it could signal to traders the price is going to fall.

Trading Strategies for Derivatives 📖

Investing in stock or bonds can be pretty straightforward. If you believe the stock’s price is going to increase, you make an investment with or without leverage and wait for the opportunity to sell their investment at a profit. With derivatives, you have the option to make money, whether the underlying asset is rising or falling in price.

The most widespread strategies for trading derivatives include purchasing multiple financial instruments to hedge the risks. One type of strategy would be purchasing the underlying asset and a call or a put option on it. This way, traders forgo the potential of unlimited gains from their position but gain insurance on the stock.

A vertical spread strategy involves holding both call and put options on the same stock with different strike prices. The difference in the strike price will be defined by whether a trader believes the underlying asset is going to fall or rise.

Traders also can purchase both calls and put options with the same strike price. This type of strategy is going to be profitable when the price of the stock moves significantly in either direction and should be implemented by experienced traders with a good options broker. An example of that could be that a company is pending an FDA approval of a new product and the result will change the price significantly.

Different Types of Derivatives 🗃

All derivatives are similar in that the value in these types of contracts derives from the underlying asset. However, each type of derivative is different and carries its own risks and benefits. Here are the most popular types of derivatives:

Futures 📆

Futures are binding contracts that require both parties to buy and sell a predetermined amount of underlying assets at a predetermined time. Despite the fact that traders are entering a legally binding agreement upon purchasing a futures contract, few end up actually purchasing the underlying assets.

Most contracts would be either sold at a profit or settled for cash by a futures broker in case the trader is at a loss. This really all comes down to the investor’s aim. Regardless of the underlying asset, be it a commodity such as oil or a security like a stock, the investor wants to make a profit, not deal with an actual asset.

Forwards 📃

Forwards are in a lot of ways similar to futures. They’re contracts that bind the selling and the purchasing party to go through with the deal at a particular time in the future at a specified strike price. The difference is, these types of contracts are not publicly traded on an exchange.

Instead, forwards are private contracts that are traded over the counter. They’re not regulated, and unlike futures, they’re not standardized. This lets the two counterparties produce a more detailed trade deal at the expense of having more risk of default.

Options 📝

Options are contracts that only give the holder the right to sell or buy the underlying asset at a strike price, before a specific expiration date. If the contract expires when the price is unfavorable to the trader, the trader does not have to close the contract—the contract just expires and the trader loses the amount of money paid for the contract in the first place.

If the price is favorable, the trader can either purchase the underlying asset and immediately sell it at a profit or sell the options contract itself. For reasons of simplicity, most traders choose to sell the contract directly.

Swaps 🔁

Swaps are a bit more complicated to trade as they’re typically traded OTC and involve swapping large sums of money, this may lead to counterparty risks. The most widespread swap contracts regulate swaps of interest rates or foreign currency. Most often, this is profitable for large international companies that need to swap fixed or floating interest rates of a loan or sums of cash needed to pay for a loan.

CFDs 📄

A contract for difference, or CFD, is a type of derivative financial product that provides traders with a way to speculate on the price fluctuations on a margin. The typical margin on this market is around 3% which gives CFD traders the opportunity to control a large position with a relatively small outlay of cash.

Let’s say a trader wants to purchase $10,000 worth of CDF contracts with a margin of 3%. To control this number of assets, you don’t need to deposit $10,000 in the account. You only need to deposit $300.

The contract itself obliges the parties involved to exchange the price difference between the prices of the underlying commodity at the times of entering and exiting the contract. So if the price moves favorably to the trader, they receive a payout, and in the other case, they’re at a loss.

Do Cryptocurrency Derivatives Exist? 🤔

Just like you can trade derivatives based on conventional market instruments such as commodities and stocks, you can also trade derivatives based on cryptocurrencies. These derivative instruments (mainly futures and options) are becoming more and more popular since 2021.

The reason behind this is that institutional traders want to receive exposure to the price fluctuations of the cryptocurrency market without necessarily purchasing the assets themselves.

The only difference with the traditional financial markets is that crypto derivatives are always at the money, meaning you can only purchase an option at the current price of the underlying asset. The strike price of traditional derivatives can be lower or higher than the current price.

Bitcoin Derivatives 🪙

Derivatives of Bitcoin are by far the most popular cryptocurrency derivatives on the market as BTC has the primary attention of investors. Especially after Bitwise published their now infamous research on Bitcoin as a part of an institutional portfolio.

BTC derivatives are trading on several exchanges including Binance with a minimum contract size of 0.001 BTC (around $38 as of today). Keep in mind though, that as options and futures are highly leveraged instruments, it’s possible to control a large value of BTC with a small outlay of cash.

Bitcoin can be a great example of how the derivatives market can be used to predict what’s happening on the spot market. Recently, the open interest in BTC futures went up to the levels of April 2021, when the price of the underlying asset was at $58k.

Ethereum Derivatives 💠

Ethereum (ETH) is the second-largest cryptocurrency in terms of both its popularity and market capitalization, so futures and options on ETH are quite popular as well. On Binance, the minimum contract size is 0.001 ETH with the maximum being 200 ETH. But again, with the leverage that is quite large on derivatives, traders can control far larger stakes of cryptocurrency than they could by simply purchasing the asset.

One aspect of trading crypto derivatives that traders should understand is that the potential for unlimited losses is even more potent with cryptocurrency than with traditional assets. Many cryptocurrencies’ prices can be extremely volatile, fluctuating by hundreds or even thousands of percent.

It’s not unheard of for a cryptocurrency to move multiple percentage points in a single day—something that is very rare in the traditional markets. Newer traders should exercise caution.

What Should You Know Before Trading Derivatives 👨‍🏫

Trading options and futures can be very profitable, but traders who are new to the world of finance are going to have a hard time turning a profit with such financial instruments. This is why before you decide to try trading derivatives, you need to educate yourself on several key aspects.

Let’s jump into some of these aspects in more detail.

Know the Underlying Asset 🧮

The first step towards deciding whether to go in on a trade or not is knowing the underlying asset and its dynamics. Technical analysis can be the primary factor in determining what direction the price will go in the following months. You should also consider giving fundamental analysis a go, at least in a simplified way.

For instance, if you know that a company is pending a major court case, the price of the stock will change dramatically, but the direction is unclear. This calls for a long straddle position in the stock.

Applying both technical and fundamental analysis can help you to better understand the underlying asset. The more you understand it, the more you’ll be able to accurately predict future price movements.

Know What to Use Derivatives For 🎯

The main thing traders should be aware of is how to use derivatives successfully. The easiest way to get into the derivatives market is by using these instruments for hedging long positions in underlying assets. This method of using derivatives doesn’t expose you to many risks, instead, it decreases them.

If you want to use derivatives to speculate on the short-term price fluctuations of the underlying asset, you’re taking on a lot of risks to increase the possible profits. Keeping an eye on the risk-potential reward ratio here is key—along with ensuring it aligns with your trading strategy appropriately.

Understand the Risks 🚧

Understanding the risks you’re willing to take is key to becoming a successful day trader. In the case of trading options to cover the existing long position, your risks are minimal and often offset by the long position.

If the price of the underlying asset moves favorably to the trader, they only lose the premium or lose out on the potential profits. In case the price stays favorable to the trader, the losses are limited as well.

The biggest potential for losses is when you’re using derivatives to speculate on the price fluctuations. Most traders will trade on a margin, meaning they would only deposit a small part of the deal in cash and use borrowed funds from a broker to acquire the rest. The margin can be quite low, ranging from 3% to 12% for different derivative instruments.

When the price moves favorably, you have the potential to profit far greater than the sum you’ve invested, minus the broker’s commission. However, when the price goes in the opposite direction, you stand a chance to lose more than your deposit. Both profits and losses are calculated on the basis of your position that often is far larger than the margin deposit.

Have a Cash Buffer 💰

The common way to speculate on derivatives safely and with little to no risk of a margin call is using leveraged funds. Yet, at the same time, having a cash buffer to cover the position is a good idea, in the event the contract starts moving in the wrong direction.

💡 Let’s illustrate this with an example: If you are entering a $10,000 trade with 3% leverage, you would deposit $300 and have $9,700 saved in case you lose the whole position.

Example of Derivatives Trading 🏗

The easiest way to understand derivatives trading is by looking at an example. Here are a couple of examples of how derivatives can be used successfully.

Example of Hedging a Long Position ⏳

One of the most common ways to use derivatives is to hedge an existing long position. Say an investor purchases 1000 shares of ABC, but believes it may suffer from a downward fluctuation in price, in the short term. This prompts the investor to buy 10 put options for the same stock.

Stock chart showing married put options strategy.
The married put options strategy is one method of hedging a long position.

In case the price does spiral down, the investor can cut the losses by selling the stock at a much higher price than what’s currently on the market. In case the price grows, the only loss that the investor experiences is the upfront premium charge on the put option. As long as the increase in price offsets the premium, the trader is realizing profits.

Example of Speculative Trading 💵

Speculative trading can be riskier but does have the potential of higher rewards in relation to the initial investment. An example of this would be entering a bull call spread trade. The trader believes ABC shares are going to rise in value but does not want to be exposed to the full risk of such an investment.

Stock chart displaying bull call spread options strategy.
The bull call spread options strategy, where a trader purchases two call options to minimize risk.

Say, a share of ABC costs $40 at the time. The trader purchases a call option at a strike price of $42 per share and sells a call option at $52 per share. The premium the trader receives for selling those call options offsets the maximum loss. If the price goes under $42, both call options expire worthlessly and the trader loses the difference between the two premiums.

If the price does go over $52, the trader would realize the $42 call option and simultaneously sell it at $52, walking off with $10 in profit per share. The profit margins can suffer in cases when the price goes significantly over $52, but this is a tradeoff for cutting losses by profiting from a premium on those higher strike price calls.

Advantages and Disadvantages of Derivative Trading ⚖

Trading derivatives combine significant risks with great chances of making a large profit. Don’t be lured in by the pros without first being aware of—and understanding—the cons. Let’s look at what you’re getting into when you think about trading derivatives. 

Pros

  • Access to valuable assets with little capital via margin trading
  • The ability to speculate on future market fluctuations
  • The ability to hedge against risks

Cons

  • Risk of default on OTC trades
  • Risk of losing more than the initial deposit
  • High volatility

The Dangers of Derivatives — Experienced Traders Only ⚠

Trading derivatives requires a disclaimer about the risks involved. Unlike with trading on spot markets, you can lose more than your deposit when trading certain derivatives.

When you enter the futures market, you’re purchasing a binding contract. If by the contract’s terms, you need to deliver a certain amount of shares at a certain price, the regulator will have to liquidate your contract even if they need to buy shares for a higher price and close your position at a much lower price.

Even if you’ve entered the contract on leveraged funds and only deposited a percentage of the full sum of the deal, you can lose more than the deposit sum. This is crucial—especially for new traders—to be aware of. A lack of properly understanding the dangers of derivatives can have dire consequences.

Conclusion 🏁

Trading futures and options can be a great way to realize large profits with relatively small upfront investments. But beginners in trading should be aware of the risks. Using leveraged funds to trade can amplify profits—but also losses.

Once you know the risks and can hedge by either having a cash deposit to cover an open position or entering advanced trades that limit losses like the bull call spread, you can trade in a safer manner.

Derivatives Trading: FAQs

  • Are Derivatives a Good Investment?

    Derivatives certainly can be a great short-term investment if you know the risks associated with using this financial instrument. Once you know the risks and can hedge against them, you can be sure that derivatives can be a profitable investment instrument for you.

  • Is Derivative Trading Profitable?

    Derivative trading can be extremely profitable, once you know how to do it and how to manage the risks. Derivatives trading can be done on margin and this increases the profit you can receive from a deal that moves in your favor. But you should keep in mind that the losses are also multiplied.

  • Can You Lose Money on Derivatives?

    You can lose money on derivatives trading, and what’s more important, you can lose more than you’ve invested. This is because you only deposit a percentage of the sum of the deal, borrowing the rest. The losses are calculated on the full size of the deal, meaning you can lose more than your deposit.

  • How Did Derivatives Trading Start?

    Derivatives are not novel trading instruments. Market participants started trading derivatives in the 17th century when farmers started looking for ways to fix a decent price on their produce. The first officially recognized derivative trading contract was signed in 1973, though.

  • When Did Derivative Trading Become Popular?

    Though it has roots in 17th-century commodity markets, derivatives trading has become popular in the 1980s. It was then that it was fully formed in the way we see it now, with regulated markets and pre-determined contracts.

  • Is Derivative Trading Difficult?

    Derivative trading is recommended for experienced traders only. Not only is it hard to predict the day-to-day fluctuations of the market, but the losses can be higher than what is currently in your account. Therefore, you need to know how to hedge against risks if you’re trading derivatives.

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