A derivative is the collective term used for a wide variety of financial instruments whose price derives from or depends on the performance of other underlying assets, markets or investments. Along with stocks and debt, derivatives are one of the three main financial instruments. The most common types of contract are known as forwards, futures, options and swaps. Importantly, derivatives can now be based on almost anything, including stocks, bonds, currencies, indices and commodities.
This guide explains how derivatives work with examples. We also cover the history of derivatives, beginner-friendly strategies, plus top trading tips. See below for a list of the best brokers for trading derivatives in 2023.
Derivatives Explained
Derivatives is an umbrella term for financial contracts which take their value from an underlying entity, such as an asset, index, or interest rate. While historically derivatives were used in agriculture as a way of hedging against fluctuations in the prices of goods, today they are considered one of the three main categories of financial instrument, alongside equity and debt, and make up a vast market whose notional value has been estimated at around $1 quadrillion – many times greater than the entire world’s GDP.
Besides more conventional products such as equity and currency derivatives, the derivatives trading field has expanded to include the latest innovations in cryptocurrencies, as Binance and other firms support trading in crypto and decentralised finance (defi).
A Brief History Of Derivatives
Although these days based on currencies, stock markets and the like; derivatives have their roots in ancient history.
The basic methodology still used today for forward and futures contracts was being developed as far back as 4500 BC, when Sumerians used clay tablets to record the amount of a certain commodity to be delivered from one party to another at a certain point in the future.
This idea became a common method of agricultural trading and was not used for much else until as recently as the 20th century.
Forex Trading
In 1970, the idea of a similar futures contract based on currencies and exchange rates was developed.
Championed by economist Milton Friedman, and helped by the establishment of floating exchange rates (where the relative value of two currencies is determined by supply and demand rather than government policy), the first foreign currency futures were officially introduced in 1972.
The principles behind what we would now term ‘call options’ also date from ancient history.
The first recorded example of such an idea dates from Greece in the 6th century B.C and involves olives.
Thales
Olives were crucial to the ancient Greeks, as they were pressed to make olive oil, which in turn provided nutrition and medicine.
Following a series of poor olive harvests, a philosopher named Thales of Miletus used his knowledge of astronomy to predict a strong harvest the following year.
He then paid a deposit for the right to rent out the local olive presses in the future. This didn’t cost him much because the previous poor harvests had driven down demand.
When the next harvest proved to be good, Thales had the rights to the olive presses and, as demand for them was now high, was able to rent them out to farmers at a profit. This is the essence of an options derivative.
Trading Derivatives vs Stocks
An easy way to gain a broad understanding of what trading in derivatives means is to compare it to the fundamental elements of trading and investing that most of us are familiar with. Traditionally, investors identify assets trading at a price they see as good value, often hoping to sell it once it reaches a target price.
A trader may borrow an asset in order to short sell it if they believe it will fall in value, or they may borrow funds in the hope of making money on a margin buy of an asset they think will increase.
In all these cases, profit (or loss) is made from the direct purchase and sale of the asset.
This is not the case in derivatives trading. Instead, derivative mechanisms are contracts whose value derives from the underlying value of an asset, but does not depend directly on its value. To illustrate this, let’s look at the main types of derivatives:
- Forward contracts
- Futures contracts
- Put options
- Call options
Forward Contracts
Put simply, a forward contract definition – or simply “forward” – is an agreement between two private parties to buy an asset for a set price at a specified date in the future. Let’s say I’m moving house, and I make an agreement to sell you my oak coffee table for $50 on 1 December, the moving date. In trading terms, the table is the “underlying” asset, 1 December is the “maturity” of our contract, and the $50 agreed price is known as the “strike” price.
So, in this scenario, how does one side stand to profit? Well, maybe in November there is a global shortage of oak, and suddenly my old table is worth much more than $50. Come the date of maturity, buyers would be lining up to take the table for $100, but I am contractually obliged to sell it to you for $50, making this a profitable trade for you.
On the other hand, if IKEA brings out a new, $50 oak coffee table before 1 December, you will be stuck with an item that suddenly doesn’t look like such good value, and I would have earned more than I could have if I’d sold it on the open market.
The value in our transaction originated from the contract we signed, not from the underlying asset itself.
This is the basic concept of a forward derivatives contract, although in practice the asset being traded is unlikely to be a used table. In financial terms, the seller holds a short position and stands to gain if the asset’s price falls by the maturity date, while the buyer holds a long position.
Forwards are privately negotiated contracts, not traded on an exchange, and the terms are flexible, making them ideal for creating complex financial instruments used by institutional investors in areas like forex. Retail traders rarely use forwards.
One way forward contracts are used outside of finance is as a hedge against price volatility. This protects buyers and sellers of commodities:
- A forward contract can protect a producer against significant decreases in the value of their goods. For example, if a maize farmer enters a forward contract, they are guaranteed a set price for their crop even if the price of maize drops before the contract matures.
- Forwards also protect buyers in similar circumstances. A manufacturer can use a forward contract to ensure they can buy the raw materials they need at a reasonable price even if the price spikes unexpectedly.
Futures Contracts
Futures contracts operate like forward contracts, with an agreement to sell an asset on a specified future date.
However, there are a few crucial differences.
Firstly, futures are financial products with set terms defining the underlying asset, maturity, and strike price. This means that, unlike highly customizable forwards, futures are standardized contracts that are readily available to retail traders through specific brokers and trading platforms.
Another important difference is that futures contracts are traded on exchanges. The price of a future changes daily until it reaches maturity to match fluctuations of the underlying asset’s price. Therefore, the profit or loss of each side of the contract is in constant flux, and the buyer and seller can lock in their profit or losses by exiting the contract at any time. They can do this by selling the contract to someone else. This will end their position but not the contract itself, which will still need to be fulfilled at the strike price when it matures.
Futures contracts can be used to hedge in a similar way to forwards. They are also often used by speculators to make bets on the direction of a price, either holding a short position by entering the contract on the seller’s side or a long position by entering as a buyer.
Another difference is that, unlike forwards, futures contracts have certain mechanisms in place to reduce risk:
- Futures contract transactions are guaranteed by clearing houses – intermediaries between the buyer and seller that ensure that both sides honor their contractual obligations. This reduces the risk of one side defaulting to near zero.
- Futures contracts are regulated by a centralized government body, such as the Commodity Futures Trading Commission in the United States, whereas forward contracts are unregulated.
As mentioned above, both futures and forward contracts are forms of derivative trading that carry the obligation to both buyer and seller that, once the contract matures, the trade will go through at the agreed strike price.
But what if the buyer or seller would like to be able to pull out of the trade?
That’s where two more of the most common derivatives trading instruments come in: options…
Put Options
A put option works in a similar way to the forward contract described above, but with one important difference: it gives the seller the option to either exercise the trade or let it expire.
With a put option, the buyer and seller still enter a contract for the sale of an underlying asset within a specific time frame and at a specified strike price, but in this case the seller also pays the buyer a certain amount – a “premium”.This premium essentially buys the seller the right to either exercise the option by selling at the agreed price or, by letting the option expire, back out of the trade.
In a put option, therefore, the option holder does not commit to sell the underlying asset, but the buyer, having accepted the premium, is still obliged to fulfil their side of the trade if the seller exercises their option.The holder of a put option stands to make a profit if the market value is lower than the strike price when they exercise their option.
As with other types of derivatives, put options are available on a wide range of assets, including stocks, indexes, currencies, cryptocurrencies and commodities.The price of the premium can vary greatly among different platforms and asset types, but is ultimately decided by market dynamics, some of which will be discussed below.
Call Options
A call option works in the same way as a put option, but in this case the roles are reversed, so the option buyer has the right but not the obligation to buy the underlying asset for a specified price within a given time frame.
In this case, the premium is paid to the selling side of the contract.
Intrinsic Value
One important thing to keep in mind when considering options is the notion of “intrinsic value” – the difference between the strike price and the market price.
- A put option is a short position, so the intrinsic value = strike price minus market price.
- A call option is a long position.The intrinsic value = market price minus strike price.
If the sum of this equation is positive, your option is considered “in the money” (ITM) – the sum is equal to the intrinsic value.If it is zero or below, it is considered “at the money” (ATM) or “out of the money” (OTM) – in either case, the option is worthless since the option holder will never exercise an option if they stand to make a loss on the trade.
For example, say you have a call option on Tesla stock at $650 and Tesla is currently trading at $690.In this case, your option is in the money, with an intrinsic value of $40.
Time Value
Another important feature of options trading is the “time value”.This represents the part of the option premium’s price that relates to the amount of time left on the contract – it is an additional amount that an investor is willing to pay for an option based on the amount of time left to make a profit.
- Time value is calculated by subtracting the intrinsic value from the option premium.
- Longer contracts tend to have a higher time value, because they have more time to become profitable.
Returning to the example of the Tesla stock from above, if the premium of this option is $45 the time value will be $5 – the premium of $45 minus the intrinsic value of $40.
This means that a buyer is willing to pay $5 over the intrinsic value for the chance to make a further profit on the call option before it expires. The time value is constantly decreasing and will reach nearly nothing as the option’s time of expiry draws near, leaving little room for price moves in any direction.
In general, you can expect to pay a high premium for options that are already ITM and an even higher premium for those with a large time value. Conversely, the premium on ATM and OTM options is lower, meaning there is often more potential for profit – provided there is adequate time left before expiry!
Swaps
Swaps are derivatives used by firms and companies and are not generally available to traders without significant capital, although some brokers do offer them. As implied by the name, a swap involves two parties exchanging financial instruments, such as interest rates, through a third party.
Hedging With Derivatives
As outlined above, derivatives are a popular method of minimizing risk, also known as hedging. The benefits of hedging with forward and futures contracts are in the security they offer.
For example: a building firm know that they will need to buy a large amount of raw materials in six months’ time. They expect material prices to rise but don’t have the capacity to buy and store now.
By buying a forward or futures contract, they can effectively freeze the current price for six months with the promise of delivery at the end of the contract.
If the price goes up during the six months, they profit from the saving made.
Options too can be effective hedging tools: If a trader holds stock in a company but fears it will significantly decrease in value in the near future, they have two choices: they can sell their stock immediately, or they can hedge by buying a ‘put’ option on the said stock.
This gives them the right to sell their shares should they drop to a certain strike price before a given date.If the shares don’t reach the strike price before the end of the contract, the trader can keep them and only loses the money paid for the put.
Speculating With Derivatives
As we saw above with Thales and his oil presses, derivatives trading can also be a good way to make a profit.One of the main reasons for this in today’s markets is the amount of leverage derivatives can offer.
For example, an investor may only need to put down 10% of the value of a contract to open an options or futures position.
At the same time, any price movements in the underlying asset are magnified by derivatives because each contract represents multiple amounts of the asset for a cheaper price than buying the asset itself, meaning there is the potential for huge profit, but equally for huge loss.
Traders interested in derivative speculation should fully understand the maths and potential risks of options and futures contracts before investing.
Pros & Cons Of Derivatives
To sum up, the main advantages of derivatives for traders are:
- Can help to hedge risk against price fluctuations
- Can offer greater leverage than trading in the underlying assets themselves
- Their liquidity makes it easy to open and close positions
Derivatives also come with inherent dangers, so much so that leading investor Warren Buffett has called them ‘financial weapons of mass destruction’.
The key disadvantages are:
- Whilst leverage offers the potential for large profits, it can also mean the potential for equally large losses.
- Derivatives require a great deal of understanding and accuracy. If not used properly, they can create systematic risk for the company and individuals using them.
- Some OTC derivatives aren’t as well regulated as others. This exposes one side to risk if the other defaults.
Derivatives Trading Education
As with any investment and trading activity, acquiring a good knowledge base is the most important step toward making returns on your trades. Before anything else, make sure you research the regulations for trading derivatives in your country, including any new rules or legislation related to crucial areas such as capital gains and income tax.
Whether you’re located in the UK, Kenya or India, become familiar with the trading hours, fees, regulatory framework and guidelines for trading derivatives in your country. You may need to research many derivatives trading companies and platforms before you find the best broker in your locale or the online platform you’re most satisfied with. It is also worth keeping up to date with derivatives trading news by following financial news, forums and websites like Reddit, and of course Daytrading.com.
Once you’re comfortable with the basics, you can start learning how to make money trading derivatives. Some people will sign up for a trading academy or even a masters degree, but there are also online courses and tutorials available, as well as a wealth of educational content on sites like YouTube.
Whatever path you decide to follow, it is always a good idea to look for the best books available as a first step – many people pick up the trading fundamentals through the humble Derivatives Trading for Dummies, for example.
Derivatives Trading Strategy
In the long run, you won’t make money trading derivatives through luck; you must start developing a good strategy as soon as you are comfortable with your understanding of the basics.
There is no magic bullet, and strategies are often dependent on context.
For example, you will need to decide on which markets you wish to trade on – are you interested in the more conventional instruments such as equities, commodities, and FX derivatives? Or are you looking to take the plunge into cryptocurrency and the world of decentralized finance (defi) and Bitcoin derivatives? Or would your background give you an edge in trading something more exotic such as energy derivatives like natural gas, crude oil or electricity?
Wherever your derivatives trading journey takes you, it is always worthwhile to sign up to a platform which will allow you to practice by making paper trades. Here are a few basic tips to help you minimise risk and increase your earnings once you start playing with real money:
- Learn to properly evaluate the maturity of your contract. A shorter contract allows less time to turn a profit from a losing position.
- Study the volatility of your chosen market. A high volatility market like cryptocurrencies can experience extreme price fluctuations in a short space of time, greatly exaggerating the margin of profit or loss.
- If you start to feel your futures contract is a lost cause, you can try to sell it on. If you can’t find a buyer, see if you can open an equal, opposite position to close out your trade.
- Derivatives offer incredible flexibility to traders looking to minimize risk and hedge their bets.
Studying different strategies for combining options trades – and learning how and when to use them – will bring impressive additions to your trading arsenal.
Final Word On Trading Derivatives
Derivatives is the umbrella term for an increasingly popular selection of trading instruments. Use our guide above to gain an understanding of how different derivative contracts work. Once you have found a suitable contract that meets your investment objectives and aligns with your risk appetite, sign up with an online broker to get started.
Further Reading