What are derivatives and how do you trade them?
Many of the most popular trading products in the world are derivatives. Discover what derivatives are, how to trade them and a few reasons why you might want to trade using them.
Start trading today. For account opening enquiries call 1800 601 799 between 9am and 6pm (AEDT) weekdays, or email newaccounts.au@ig.com.
Contact us: 1800 601 799
Start trading today. For account opening enquiries call 1800 601 799 between 9am and 6pm (AEDT) weekdays, or email newaccounts.au@ig.com.
Contact us: 1800 601 799
What is a derivative?
A derivative is a contract between two or more parties that derives its value from the price of an underlying asset, like a commodity. Derivatives are often used as a means to speculate on the underlying’s future price movements, whether up or down, without having to buy the asset itself.
As no physical assets are being traded when derivative positions are opened, the contracts can be traded over the counter (OTC) or on an exchange. You can take a position on a large range of underlying assets, including:
Types of derivatives
There are various types of derivatives. These all have unique characteristics and are used for different reasons. However, derivatives like options and futures contracts can be difficult to trade as they often require large capital outlays or accounts with brokers that buy and sell on your behalf.
An alternative is to use a provider like us to speculate on the price movements of a derivative via CFD trading.
CFDs are also a form of derivative as they track the price of an underlying market.
For example, you can take a position on a futures contract listed on an exchange without buying or selling the actual contract. Rather, you’d use CFD trading to gain exposure to your prediction as to whether a market will rise or fall, based on market conditions. If you think the price will rise, you’d buy (go long) whereas if you think it’d fall, you sell (go short).
While this means you can make a profit or a loss whatever the market’s doing – based on whether you predicted its movements correctly or not – this form of trading isn’t without risk. Short-selling in particular can bring significant losses, as there’s no limit to how high a market’s price can rise.
CFDs are leveraged forms of trading, meaning that you’ll put up a small initial deposit (called margin) to open a larger trade. This is a small percentage of the total value of your position. However, it is important to be aware that CFDs are complex products that may magnify any potential profits and losses, making them a high-risk trading strategy that could potentially result in the loss of more than your initial deposit.
CFD trading
When you trade CFDs, you’re entering into a contract for difference, which is an agreement to exchange the difference between the opening and closing price of your position.
CFD trades enable you to speculate on the price of an asset by going long (buying) or going short (selling) - without taking ownership of the asset. You can trade on the spot, as well as options and futures prices with CFDs.
CFDs are complex products that may magnify any potential profits and losses, making them a high-risk trading strategy that could potentially result in the loss of more than your initial deposit.
Futures contracts
Futures are financial contracts in which two parties – one buyer and one seller – agree to exchange an underlying market for a fixed price at a future date. Futures give the buyer the obligation to buy the underlying market, and the seller the obligation to sell at or before the contract’s expiry.
The unique aspects of futures contracts are that they are standardised and traded on exchanges. The exchanges guarantee payment, so counterparty risk is lessened on the exchange-listed contract. You can trade on futures markets with us using CFDs.
Futures are also leveraged, so it’s important to remember that your profit or loss will be determined by the total size of your position, not just the margin used to open it. This means there is an inherent risk that you could make a loss (or a profit) that could far outweigh your initial capital outlay.
Options contracts
Options give one party the right (but not the obligation) to purchase or sell an asset to the other at a future date at an agreed price. If the contract gives the option for one party to sell an asset it is called a put option. If it gives the option for one party to buy an asset it is called a call option. You can trade on options prices with us using CFDs.
Options are leveraged products much like CFDs; they allow you to speculate on the movement of a market without owning the underlying asset. This means profits can be magnified – as can your losses, if you’re selling options.
When buying call options as CFDs with us, you’ll never risk more than your initial payment when buying, just like trading an actual option, but when selling call or put options your risk is potentially unlimited (although your account balance will never fall below zero).1
What is derivatives trading?
Derivatives trading is when you buy or sell a derivative contract for the purposes of speculation. Because a derivative contract ‘derives’ its value from an underlying market, they enable you to trade on the price movements of that market without you needing to purchase the asset itself – like physical gold. You’d do this in the hope of making a profit.
Derivatives can be traded over the counter (OTC) or on-exchange:
- Over the counter: the terms of the contract are privately agreed between the parties involved (a non-standardised contract). For example, a contract between a trader (like you) and a broker (like us)
- On-exchange: another way to trade derivatives is through a regulated exchange that offers standardised contracts. These are called exchange traded products (or ETPs) and they provide the benefit of having the exchange act as an intermediary. Because the exchange guarantees payment, counterparty risk is vastly reduced
When trading derivatives with us you’ll be taking a position using CFDs which is an OTC product. You can also use these OTC products to take a position on futures and options prices. This means that instead of trading on exchanges – which can be difficult and costly – you’ll be speculating on price movements exclusively.
What is the derivatives market?
The derivatives market is not a single, physical place. Instead, it consists of all OTC and on-exchange financial instruments that derive their worth from an underlying asset.
The derivatives market plays an important role in the global financial system. Well-known exchanges listing derivatives include:
- The Chicago Mercantile Exchange (CME), which is one of the world’s oldest exchanges and trades derivatives like futures and options linked to commodities and sectors, most famously the agricultural sector and soft commodities
- The Intercontinental Exchange (ICE), which trades derivatives linked to foreign exchange, commodities and more
- The ICE Futures Europe exchange, formerly known as the London International Financial Futures and Options Exchange (LIFFE), which is one of the foremost exchanges in the UK and trades options and futures, most notably on Brent Crude oil
Physical delivery and cash-settled derivatives
Although no asset is bought or sold when a derivative contract is opened, many derivatives may require the physical delivery of the underlying at a specified price on a future date.
Whether the contracts are settled with physical delivery or by cash payments from one party to another depends on the terms of the contract.
- Cash-settled derivatives – this is a type of agreement in which the physical underlying asset is never involved in the transaction. Instead, the contract is settled with a monetary amount which represents the value of that underlying (for example, for the current price of a gold ingot). All derivatives traded with us are cash-settled
- Physical delivery derivatives – this contract is an agreement to exchange the actual underlying, which must be delivered by one party to the other at the derivative’s expiry date. This can be less convenient for the trader in terms of taking possession of, storing and selling or maintaining the asset, for example if the underlying being traded is livestock, large amounts of precious stones, etc.
Why trade derivatives?
Here are four reasons why you may want to consider trading derivatives:
- Speculation
With speculation you won’t take ownership of the asset class but can still make a profit (or a loss) on various financial assets, simply by making a prediction on the market direction. You’d either buy or sell derivatives in the hope of your prediction being correct. For example, if you think the ASX 200 (known as the Australia 200 on our platform) is set to rise over the coming weeks, you could buy CFDs on an ASX 200 futures contract. If, however, you think the ASX 200 may depreciate in price, you’d sell (go short) with CFDs.
- Trading rising and falling markets
With derivatives, you can trade both rising and falling markets, meaning you can profit (or make a loss) even in a depressed or volatile economic environment. You’d go ‘long’ if you think the price of an underlying asset will rise; and ‘short’ if you think it’s going to fall. To open a long position, you’d elect to ‘buy’ the market. When going short, you ‘sell’ the market when opening your trade.
- Trading with leverage
You can use derivatives to increase leverage. This enables you to open a position by putting down a deposit worth a fraction of the trade size in order to open a larger position. However, be aware that this magnifies the size of both the potential profits and the losses that can be made and could potentially result in the loss of more than your initial deposit.
- Hedging
Traders, investors or businesses can also use derivatives for hedging purposes, which means opening a second position that will become profitable if another of your positions starts to make a loss. In this way, you can mitigate your risk by gaining some profit and mitigating some losses overall, without having to close your initial position.
How to trade derivatives with us
With us, you can trade 17,000 markets using CFDs. When trading contracts for a difference (CFDs), you’ll be exchanging the difference between the opening and closing price of your position.
In addition to around 12,000+ popular stocks and 3400 ETFs from exchanges around the globe, you can also take positions on the prices of exchange-listed options and futures. All our trades are cash-settled. To take a position on a market with CFDs:
- Create an account or try a demo account
- Select your preferred market
- Take steps to manage your risk
- Place your trade and monitor your position
Examples of derivatives trading
Speculation
Say you want to speculate on the price of the ASX 200. You’d need to use a type of derivative, in a trading platform, to do this. Let’s look at a Futures CFD example.
After some thought, you decide to use CFD trading to take out a longer-term position predicting what the ASX 200 (known as the Australia 200 on our platform) will do in the future – this is called a futures contract.
If you think the ASX 200 exchange is set to rise over the coming weeks, you’d buy a futures contract (also known as going long), but would sell (go short) if you thought the ASX 200’s price would fall.
Let’s assume you think the ASX 200 will appreciate in price. So, you decide to go long, with $100, speculating that the exchange’s market price will go up by your futures contract’s expiry date. If the exchange’s price does go up by 5 points, you’ll make a profit of $500 ($100 x 5 points). If the ASX 200’s price falls by 5 points, you’d make a loss of $500 instead.
Hedging
Let’s look at an example. You think the price of Brent Crude may go down, so you want to hedge your oil shares with us using CFDs. So, you go short on 10 Brent Crude oil CFD contracts. CFDs are calculated based on the difference between the market price when you open your position vs when you close it, and a single standard Brent Crude oil contract is equal to $10 per point.
So, for each point the Brent Crude price falls, you’d make $100 ($10 multiplied by 10 contracts). Likewise, for every point that the oil price appreciates, you’d make a $100 loss.
FAQs
Are derivatives leveraged?
Yes, derivatives are leveraged products. This is because all derivatives involve putting up a smaller amount initially in order to open a larger position, rather than paying the full amount of an asset upfront as you would with investing. However, some brokers offer unleveraged derivatives.
Are derivatives traded on an exchange?
On-exchange derivatives (also known as exchange-traded products or ETPs) are traded on an exchange, while over-the-counter (OTC) derivatives aren’t.
Are CFDs derivatives?
Yes, CFDs are a type of derivative you can trade with us.
Where can I trade derivatives?
You can trade derivatives in many different ways, on an exchange and/or OTC, most commonly through a broker. We offer OTC CFD derivatives on our award-winning platform,2 and are the No. 1 CFD provider in Australia.3
What markets can I trade with derivatives?
There are many markets you can trade with derivatives – in fact, we offer over 17,000 to choose from. With us, you can use CFDs to trade on futures and options, indices, thousands of shares, currency pairs (forex), commodities, interest rates, bonds and more. See our markets to trade for more info.
How can I trade derivatives?
First, you’ll decide whether you want to trade derivatives via CFDs. If so, then you’ll open an account with us and open your first position. If you would like to get a feel for trading derivatives first, you can instead open a demo account with us.
Try these next
Find out what futures are and how to trade them
Learn the basics of trading options with us
Discover how to trade in real-time with spot trading
1 Negative balance protection is not available to Pro clients.
2 Best Finance App, Best Multi-Platform Provider and Best Platform for the Active Trader as awarded at the ADVFN International Financial Awards 2024.
3 Number 1 in Australia by primary relationships, CFDs & FX, Investment Trends November 2023 Leveraged Trading Report.
Contact us
Interested in opening an account?
Contact 1800 601 799 or newaccounts.au@ig.com
Want to check on your application’s progress?
Email newaccounts.au@ig.com
Have another question?
Browse our Help and Support portal
WhatsApp: Click
here
IG | Sitemap | Terms and agreements | Privacy | How to fund | Vulnerability | Cookies | About IG
