Derivatives trading explained

Derivative markets serve important roles in the global financial system. While derivatives can be complex, they represent the modern day versions of practices that have been around for thousands of years, when individuals would place bets with one another or farmers would agree to sell their crops in advance as a form of insurance.

For individual traders, derivatives trading has opened up a wide array of markets for them, allowing them to speculate when the price of something will rise or fall. However, traders must fully understand derivatives markets before they can trade them, as well as the different types of derivatives and derivative products that are available.

Let’s have a look at what derivatives trading is all about.

What is derivative trading and the derivatives market?

‘A derivative is an investment that depends on the value of something else,’ – Collins English Dictionary.

A derivative is a contract between two or more parties that is based on an underlying financial asset (or set of assets). Derivatives are used by traders to speculate on the future price movements of an underlying asset, without having to purchase the actual asset itself, in the hope of booking a profit. Traders or businesses also use derivatives for hedging purposes, in order to mitigate risk against another position they have taken in the market.

There is a wide variety of assets that are used to form the basis of derivatives trading, allowing traders to take positions on currencies, commodities, shares, indices, bonds and interest rates.

Importantly, derivatives allow traders to take both long and short positions on an asset such as a stock, letting them bet whether a share price will rise or fall in the future.

Find out more about short-selling, or learn how you can start trading online in the UK

How can you trade derivatives

Derivatives can be traded in two distinct ways. The first is over-the-counter (OTC) derivatives, that see the terms of the contract privately negotiated between the parties involved (a non-standardised contract) in an unregulated market.

The second way to trade derivatives is through a regulated exchange that offers standardised contracts. This provides the benefit of having the exchange act as an intermediary, helping traders avoid the counterparty risk that comes with unregulated OTC contracts.

There are many derivative products, all with significant differences that are important for traders to understand. Below you can find the 2 most widely used derivatives used by traders:

1. CFDs (contracts for difference): CFDs are an agreement between two parties to pay the difference in the price of an asset between the time a position is opened and when it is closed
2. Options: options give traders the right (but not the obligation) to purchase or sell an asset at a certain price within a certain timeframe

You can learn more about options and how they work here.

Types of derivatives

There are various types of derivatives that can be traded. These all have unique characteristics that seperate them from one another, and are used by traders for different reasons. Forward and futures contracts are both used to speculate and bet on the future price movements of an asset, or as a hedging mechanism. Options allow traders to hedge against potential price declines, while swaps are used as a way to hedge against risks surrounding debt, foreign exchange movements and fluctuations in commodity prices.

Below is a breakdown of the main types of derivatives:

1. Forward contracts: a forward contract involves a buyer and seller. The two agree to trade an asset at a future date, but at a price that is agreed today. The contract is settled on the agreed future date, when the buyer pays for (and in some cases, receives) the asset from the seller at the agreed price, and the profits and losses are realised based on the movement in price of the underlying asset between the start date and end date of the contract. These are traded OTC, with the terms privately agreed between the parties involved.
2. Futures contracts: futures contracts evolved out of forward contracts and therefore carry many of the same characteristics. The unique aspects of futures contracts are that they are standardised and traded on exchanges, and are subject to a daily settlement procedure. This means the parties in the contract settle daily over an agreed time period, with the party that has suffered losses paying the other party that has made a profit on a daily basis.
3. 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.
4. Swaps: swaps are a completely different form of derivative that involves two parties exchanging one another’s cash flow, or a variable attached with various assets. There are different types of swaps, some of the most common of which are listed below:

Derivatives trading example: hedging

Hedging is used as a form of insurance. As an example, fictitious baking company Baker Corp purchases and consumes a large amount of flour in order to create its products. However, the company is concerned that its margins will be squeezed if the price of flour rises in the future. Baker Corp therefore decides to enter into a contract with a supplier of flour, agreeing to purchase ten sacks of flour in six months’ time for £15 each.

Baker Corp now has a guaranteed supply of flour at a guaranteed price, protecting it from any potential increases in the spot price of flour over the next six months. In turn, the supplier knows it will be able to sell its future production at a set price, mitigating any potential declines in the spot price of flour.

Six months later, at the agreed date, the spot price of flour has soared to £20 per sack. But Baker Corp still pays the agreed price of £15 per sack, saving the £5 per extra per sack it would have had to pay on the spot market. However, the supplier has lost out, missing out on the opportunity to sell those sacks of flour on the spot market at a higher price.

Learn more with IG’s glossary of trading terms

Derivatives trading and leverage

As well as speculating on the price movement on an asset and hedging a position, traders use derivatives to increase leverage. This allows traders to take a larger position on key markets compared to the capital they must deploy, magnifying the size of both the potential profits and losses that can be made.

For example, traders may use leverage to take a position on a stock at a fraction of the cost of the actual share price of the stock.

Read more about the impact of leverage on your trading

The more volatile a market is, the more magnified the returns traders receive from trading derivatives as the price of the underlying asset moves more dramatically. Therefore, higher volatility means the value and cost of both puts and calls increase. Traders use the likes of the Chicago Board Options Exchange Volatility Index (VIX) to monitor how volatile certain financial markets are, in this case the S&P 500.

Round-up: derivatives markets

Derivatives have become popular because they are based on the monetary value of an asset rather than the tangible asset itself, allowing businesses or individuals to trade in the likes of stocks, currencies, and commodities without having to actually buy them. This allows derivatives trading to centre on and be settled in cash, without the actual asset having to be delivered.

Derivatives markets also allow traders to utilise leverage, allowing them to take a much more significant position compared to the amount of capital they must deploy, maximising the potential profits, as well as the losses.

For businesses, derivatives play a vital role in the financial system by acting as a form of insurance through the hedging process, allowing them to avoid negative price movements and mitigate losses, regardless of which way prices move.