What are financial derivatives?
What are financial derivatives?
A derivative in financial markets is a product with a value deriving from an underlying variable asset like a stock index or a commodity such as oil and gold. Derivatives mirror price movements. If an index like the Dow Jones or the ASX 200 rises, the derivative will follow.
Physical asset or derivative?
Instead of investing in a physical asset like company shares, derivatives allow traders to speculate on the performance of an overall index or market.
A financial derivative is also defined as a contract between two parties to open a position, where both parties agree to exchange the difference in price movements, once the position is closed.
Depending on the type of derivative chosen by a trader, there are two different types of contracts. The first being an over-the-counter derivative which is a private contract between a trader and a broker, without having to use an exchange. Risk and return on these derivatives can be negotiated and customised to suit both parties.
The second contract is a listed derivative in which a contract is set by an exchange. A listed derivative is standardised and more structured than over-the-counter derivatives.
Types of derivative contracts
There are several types of financial derivatives accessible to traders depending on what suits your needs.
Contract for Difference (CFD)
A contract for difference or CFD is an over-the-counter derivative allowing retail traders to gain exposure to indices, commodities, and cryptocurrency prices. The trading alternative was first introduced in the early 1990s before becoming available to Australian brokers and traders in 2002.
CFDs are a leveraged products, which means traders only need to deposit a small percentage (often 5%) of the instrument’s total value to open a position.
This is called a margin or trading on a margin.
If the instrument moves in your favour, traders will make a gain. However, if the instrument moves the other direction, traders risk a loss and could potentially lose more than their initial deposit.
Options
An option is a contract that gives an investor the right to buy (call option) or sell (put option) a financial derivative or underlying asset without the obligation to do so. Options can be used for hedging against futures contracts and include an agreed-upon price, as well as a time and date between the option writer and the option buyer.
Because the buyer has the advantage of not proceeding with the contract, there is a fee or cost involved by the seller, known as a premium. A premium is paid up-front by the buyer at the start of the contract and are quoted on a ‘cents per share’ basis. This is because the seller knows an option is likely to be exercised when the price moves in favour of the buyer. All options (call or put) have an expiry date, where the contract will lapse and is no longer valid.
Those seeking to invest or speculate in options must do so directly through an exchange (i.e. ASX or CME) via a broker. The exchange sets the rate and the premium of its options contracts. Eightcap does not offer options as part of its services.
Futures
Futures trading or a futures contract is an agreement between a buyer and a seller to trade an asset at a future date and price, specified by the buyer. It began as a hedging technique for agricultural farmers, resulting in the grain futures and the dairy futures market in New Zealand. It was used as a safeguard to fix prices or rates for future transactions.
Today, these contracts are available through the Australian Securities Exchange (ASX) along with a range of other commodities, bonds and assets. Essentially, financial futures involve the trading of contractual rights and obligations as opposed to the trading of financial securities.
The contracts are standardised and can only be executed through futures exchanges across the globe, like the Chicago Mercantile Exchange (CME). To ensure both parties meet their contractual obligations, a third party known as a clearing house is used as an intermediary to settle accounts.
Clearinghouse
A clearing house is used for both futures and options trading and is usually a subsidiary or associated with the exchange itself. An initial margin or deposit is required by the clearing house whenever a futures position is opened. Extra payments, referred to as margin calls, are requested by the clearing house whenever there is an adverse price movement. A clearing house has the right to cancel a trader’s position if margin calls are not paid, without refunding the deposit or previous margin calls. When futures contracts are closed, traders who have made a profit are paid by the clearing house and vice-versa.
Forward
In financial trading, a forward contract or forward is a derivative that allows two parties to buy or sell an asset at a specified price, at a future date. Unlike futures, a forward contract agrees upon a price before a position is opened, known as a delivery price. Forwards also don’t require an exchange to open a position and is therefore considered an over-the-counter instrument.
A forward contract can be customised to a commodity and is settled at the end of a contract, whereas futures are settled daily. Because forward contracts are OTC, there is no clearing house involved, and therefore a higher risk of default by either party. A forward, like futures, is also used to hedge risk by speculating the future value or price of an asset.
Swaps
A swap is completely different to other financial derivatives. Its primary purpose is to engage trade between businesses, financial institutions and governments, rather than retail investors.
Swap contracts are an over-the-counter instrument and can be based on interest rates, foreign exchange rates (currency), commodities, etc. One stream of cash flow is generally at a fixed rate while the second leg of the swap is floating/variable.
Example
An interest rate swap involves two parties exchanging cash flows on a notional principal amount, in a bid to speculate or hedge against interest rate movements/risk. The most common type of interest rate swap is when one party agrees to make payments to a second party based on a fixed interest rate, while the second party makes payments to the first party based on a variable rate.
The notional principal amount is never exchanged, only the difference in interest payments. Governments across the globe regularly enter interest-rate swaps with banks to hedge against interest rates and (hopefully) save money.
Benefits of financial derivatives
Trading financial derivatives, whether it’s a contract for difference (CFD) or a futures contract, serves many purposes with several benefits.
Advanced investment strategies
Just like shares, it’s important to have a diverse range of investments in your portfolio and derivatives can do just that. Derivatives provide traders with an advanced strategy because of the liquidity and pace the markets are traded. They allow investors to trade against price movements without having to buy or sell the physical asset. Derivatives are also used for risk management against other investments via hedging strategies and can be traded long or short.
Leverage returns
Unlike investing in shares, where investors must pay the full value of a stock, derivatives only require a small percentage of the underlying asset’s value to start trading. The deposit, known as a margin, is generally only 5 per cent of the value. Because of this, derivatives provide a cheaper entry point to the market. Traders only need a few hundred dollars to start.
Derivatives are also leveraged products, which means the margin can be used to leverage your investment to enter larger trades. Leverage essentially increases your buying power to magnify your gains but can also magnify your losses.
Example
If you have an account leverage of 1:1 and wish to trade $100, you will only have exposure to $100. However, if you have an account leverage of 100:1, then you will have exposure to $10,000 (100 x $100). Eightcap offers accounts with leverage up to 500:1.
Non-binding contract
When purchasing a derivative, investors are purchasing the right to trade without the obligation to do so. Unlike shares, when you purchase a derivative like an option, traders do not have to proceed with the contract. Instead, they pay a premium from the start. This of course does not apply to swap agreements, which are legally-binding contracts between the two parties (i.e. a bank and a government). Most other derivatives are easily accessible to retail traders through platforms like Meta Trader 4 and Meta Trader 5.
Disadvantages of trading derivatives
With any financial investment, whether it’s shares, property or a derivative, there are risks and disadvantages to be aware of.
Market risk
With any investment, if the market moves against your position or not in your favour, traders will be at risk of a loss. Global markets can be unpredictable and volatile, and there is no guarantee the market will move to your advantage. Investments can be protected through hedging strategies but again, there is no guarantee.
Default
Traders using high-leveraged derivatives to speculate on price movements can magnify gains but also magnify losses. This means you can potentially lose more than your initial deposit or margin and owe the other party or financial broker large amounts of money. If traders do not have the outstanding funds, they can default on the contract and be at credit risk.
Spreads
Some financial derivatives, like a CFD, require traders to pay a spread. A spread is the difference between a buy (ask) and the sell (bid) price quoted for an instrument.
Time Restrictions
Some financial derivatives have maturity dates, likes options, and will expire on the maturity date, whether it’s been exercised or not.
How to trade derivatives
As mentioned earlier, financial derivatives can be purchased through an exchange (via a broker) or over-the-counter (private contracts). OTC derivatives like CFDs are available to anyone seeking to diversify their portfolio.
In Australia, traders must first open an account with an ASIC-registered broker like Eightcap. They will then have access to a trading software or platform like Meta Trader 4 or Meta Trader 5.
Beginner traders are urged to practice trading, short and long positions, on a demo account before opening a live account. Once a live account is operational, traders will have access to major currency pairs, exotic currency pairs, commodity prices, major indices and even crypto-currency prices. The platform will allow traders to open and close positions to their own discretion.
Financial derivatives that are regulated or traded on an exchange, like a futures contract, require a broker to act on behalf of a trader. Therefore, traders must place an order with their broker to buy or sell one or more futures contracts. When another participant in the market chooses to trade with you, a contract is then registered with the exchange’s clearing house before your position is opened.
Once a futures position is opened, traders can choose to hold their position until maturity or close out their position by selling or buying futures with the same maturity date. Closing out your position means you are closing your trade.
Are financial derivatives right for you?
There is no financial investment without some level of risk. When trading financial derivatives, traders should invest and behave responsibly. Risk management and discipline should be included in your trading plan when using leverage or leveraged products. While derivatives can add to your investment portfolio, you should consider whether the products are suitable for your needs and seek financial advice if you are uncertain.