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It is well known that trading in the financial markets can be highly volatile and risky.
This is why financial instruments, like derivatives, have been set in place to protect traders and investors from the volatile prices of commodities, currencies, and stocks traded in the financial market.
With derivative trading, it has become easier for traders or investors to predict the future price of an asset through the buying or selling of derivative contracts. Their main goal is achieving higher returns when compared to buying the underlying asset directly.
What is Derivatives Trading?
Derivative trading consists of buying and selling contracts linked to underlying assets, providing access to different markets and opportunities.
These contracts derive their value from assets like stocks, bonds, market indexes, commodities like oil and precious metals, currencies, and interest rates…
Derivatives serve as powerful tools for traders and investors to manage risks, speculate, and get access to diverse market segments.
How Does it Work?
To make informed decisions, traders tend to analyse market trends and economic factors, by taking either long or short positions.
This form of investing is considered unique, and allows hedging against risks and leveraging existing holdings.
Not only this, but traders are capable of balancing their portfolios more, and eventually minimising exposure to adverse and extreme market conditions – especially volatility.
While leverage can generate profits, it also amplifies potential losses, which is why risk management is not only important, but also crucial.
Types of Derivatives to Trade
In derivative trading, various instruments enable market participants to resort to diverse strategies and seize specific market opportunities.
Let’s explore some common types of derivatives:
1. Futures Contracts:
By definition, futures contracts are standardised agreements between parties to buy or sell a certain asset, at a predetermined price in the future.
Traded on exchanges, they provide a regulated marketplace for risk management and speculation.
Both parties are obligated to fulfil the contract.
Similar to futures contracts, forwards involve agreements to buy or sell an asset at a predetermined price on a future date. They differ from futures by the fact that they are traded over the counter (OTC).
Since forwards are customisable in size and settlement terms, they can carry higher risk.
3. Options Contracts:
Options grant the buyer the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specified price by a predetermined expiration date.
They are considered to be a valuable tool for hedging and speculation, and they offer flexibility in contract exercise.
Swaps involve the exchange of cash flows between two parties based on specific predetermined terms.
They are often used to manage risks, optimise cash flows, or take advantage of interest rate differentials.
For example, an interest rate swap allows two parties to exchange fixed and variable interest rate cash flows, which enables them to manage their exposure to interest rate fluctuations.
What is CFD Trading?
CFD stands for Contract for Differences.
CFD is a financial instrument or contract that allows traders or investors to speculate on future movements of the market when it comes to an underlying asset, without necessarily owning the underlying asset itself.
- Traders form contracts, paying the difference between current and contract time values.
- CFDs offer flexibility and profit potential in rising and falling markets.
- Margin amplifies exposure and profits, but also increases risks.
It grants access to diverse markets, leveraged positions, and flexible trade sizes.
- Traders can take either long and short positions.
- Understanding risks and using risk management strategies are crucial for responsible trading.
Derivative Trading Strategies
Traders employ various strategies to be able to manage risk and generate profits – that’s where derivative trading plays its role.
These strategies typically use financial instruments such as options or futures to get to their main goals.
Most popular trading strategies are as follows:
Hedging is a risk management strategy used to protect against adverse price movements of a certain asset. Traders often use options to hedge their positions.
For example, an investor holding a stock may buy a put option to safeguard their portfolio in the face of potential price declines.
In the context of trading in financial markets, speculation is the act of conducting a trade or market transaction that has both the potential profits, and the possibility of severe losses.
To be more specific, traders can speculate on both upward and downward price movements.
3. Leveraging a Position:
Leveraging a position is about using borrowed funds to amplify potential returns.
Traders can leverage their investments by purchasing derivatives with borrowed capital.
This allows them to control a larger position size with a smaller initial investment. However, leveraging also amplifies potential losses.
Other strategies include trend following, mean reversion, momentum trading, and swing trading.
These strategies can be used in various markets and with different financial instruments, including derivatives.
Trading Derivatives in the Financial Markets
When trading derivatives, there are two main methods to be followed:
- Over-the-counter (OTC) trading
- Trading on regulated exchanges
OTC trading usually takes place in an unregulated market, and involves privately negotiated contracts with flexible terms tailored to specific needs.
When trading on regulated exchanges, you are getting involved in standardised contracts with predefined terms. Such exchanges provide liquidity, transparency, and a centralised marketplace.
You can trade derivatives by opening an account with any brokerage firm that offers derivative trading services, such as BitDelta.
Access the market through the brokerage platform, where buy and sell orders for specific derivative contracts can be placed.
Understanding the risks, characteristics, and employing risk management strategies are important steps towards the success of your trading journey.
Different derivatives like options, futures, swaps, and forwards have unique characteristics and trading procedures.
It is always advised to seek professional advice if need be, and conduct research to gain a deeper understanding of the markets.
Frequently Asked Questions
What is derivative trading?
Simply put, derivatives are financial instruments whose value is “derived” from an underlying asset.
Derivatives can be traded on exchanges or over the counter, and are useful for risk management and speculation.
Examples of Derivatives Trading?
Examples of derivatives trading include:
- Options – they grant the right to buy or sell an asset at a specified price
- Futures – require buying or selling an asset at a predetermined price on a future date
- Swaps – involve exchanging cash flows based on predetermined terms
- Forwards – they are agreements to buy/sell an asset at a future date and for a specific price
What is CFD trading?
CFD trading, or Contract for Difference Trading, is a type of derivative trading that involves individuals speculating on the price movements of various financial instruments, such as stocks, commodities, or indices, without owning the underlying asset.
Profits or losses are based on the difference between the opening and closing prices of the contract.
How to make money trading derivatives?
To make money in derivative trading, you’d need to buy or sell derivatives at advantageous prices, and subsequently profit from price movements of the underlying assets.
Traders can achieve profits by accurately predicting price directions and using strategies like hedging, speculation, or leveraging positions.
However, derivative trading carries risks, necessitating a comprehensive understanding of the market and the implementation of appropriate risk management techniques.
How do I start trading derivatives?
To start trading derivatives, follow these steps:
- Educate yourself about derivatives, trading strategies, and market dynamics.
- Select a reputable brokerage firm that offers derivative trading services
- Fund your trading account with capital for trading.
- Develop a trading plan that defines goals, risk tolerance, and strategies.
- Practice with a demo account offered by many brokerages.
- Start trading derivatives by placing buy or sell orders through your chosen brokerage’s trading platform.