Trading Derivative Markets: What Are Financial Derivatives?

The global trading markets are composed of a wide array of financial products and instruments, and learning the intricacies of each is a good way for the beginning trader to start formulating their personal approach. One popular sector of the market is formed around derivatives - but what are derivatives and how do they work?

What Is a Derivative?

Derivatives, a cornerstone of modern finance, encompass a wide array of financial instruments whose value hinges upon the performance of an underlying asset, group of assets, or benchmark. These intricate contracts are negotiated between two or more parties, facilitating trading either through established exchanges or over-the-counter (OTC) channels.

At their core, derivatives serve as a means to manage risk, offering avenues for both hedging against potential losses and speculating on market movements for potential gains. By their very nature, derivatives can transfer risk from risk-averse entities to those more inclined to take on risk in pursuit of higher returns.

Derivatives manifest in various forms, ranging from futures contracts and forwards to options and swaps. Each derivative type presents distinct characteristics and applications, providing investors and institutions with versatile tools to navigate financial markets.

The dynamics of derivatives revolve around the fluctuations in the prices of their underlying assets. These assets span a spectrum, encompassing stocks, bonds, commodities, currencies, interest rates, and market indexes. Consequently, the values of derivative contracts fluctuate in tandem with changes in the prices of these underlying assets.

One of the primary functions of derivatives is hedging, wherein investors attempt to mitigate their exposure to market risks. For instance, a company may utilise derivatives to hedge against fluctuations in commodity prices, ensuring stability in its operational costs.

Conversely, derivatives also serve as potent tools for speculation, enabling investors to capitalise on anticipated market movements. By assuming positions based on forecasts of asset price trends, traders can potentially make use of derivatives to amplify potential returns. However, this speculative aspect of derivatives inherently entails heightened risks, as gains and losses can be magnified through leverage.

Leverage, a characteristic prevalent in many derivatives, amplifies both potential rewards and risks. While leverage enhances the profit potential of derivative investments, it also exposes participants to increased susceptibility to market volatility. Consequently, prudent risk management is imperative when engaging in leveraged derivative transactions.

In the realm of derivatives trading, exchanges such as the Chicago Mercantile Exchange (CME) serve as pivotal platforms for market participants to engage in derivative transactions. These exchanges provide liquidity and transparency, facilitating the efficient trading of derivative contracts among diverse market participants.

Despite the potential benefits derivatives offer, OTC-traded derivatives introduce additional complexities and risks, particularly counterparty risk. In OTC transactions, counterparties face the peril of default by the other party involved. To mitigate this risk, investors may employ various derivative instruments, such as currency futures and swaps, to hedge against potential losses stemming from counterparty defaults.

In essence, derivatives epitomise the multifaceted nature of financial markets, providing investors with indispensable tools to manage risk, speculate on market movements, and optimise investment strategies. However, their intricate dynamics necessitate thorough understanding and diligent risk management to navigate effectively within the derivatives landscape.

Financial Derivatives Trading

Like other sectors of the financial markets, derivatives and the ways they are traded are highly diverse and may require some study to fully understand. Let’s dive in:

Derivatives Market Explained

The derivatives market represents a vast ecosystem of financial instruments, comprising both over-the-counter (OTC) and exchange-traded contracts, all deriving their value from an underlying asset. Unlike traditional markets, the derivatives market transcends physical boundaries, existing as a decentralised network of transactions conducted globally.

Integral to the functioning of the global financial system, the derivatives market serves as a mechanism for managing risk, facilitating speculation, and optimising investment strategies. Notably, prominent exchanges such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) are instrumental in providing platforms for trading derivatives.

The CME, renowned as one of the oldest exchanges worldwide, hosts a diverse array of derivatives, including futures and options tied to commodities and sectors. Notably, its offerings span the agricultural sector and soft commodities, providing market participants with avenues for hedging and speculation.

Similarly, the ICE boasts a comprehensive suite of derivative products, ranging from foreign exchange to commodities and beyond. Within its purview, the ICE Futures Europe exchange, formerly known as LIFFE, stands as a cornerstone of the UK's financial landscape. Here, options and futures contracts, prominently featuring Brent Crude oil (EB), are traded, catering to the needs of investors seeking exposure to energy markets.

In essence, the derivatives market represents a dynamic ecosystem characterised by its versatility, liquidity, and global reach. Through exchanges like the CME and ICE, market participants gain access to a myriad of derivative instruments, empowering them to navigate market dynamics, hedge risks, and pursue investment opportunities across diverse asset classes and geographies. Now let’s take a look at two major divisions of derivatives, over-the-counter (OTC) and exchange-traded derivatives:

OTC Derivatives

An Over-the-Counter (OTC) derivative is a bespoke financial contract structured to meet the specific requirements of the involved parties, unlike exchange-traded derivatives. Unlike their exchange-traded counterparts, OTC derivatives operate within a more decentralised framework, traditionally characterised by minimal intermediation and regulation.

OTC derivatives, such as forwards, swaps, and exotic options, are privately negotiated contracts between counterparties, often facilitated by brokers. Despite offering tailored solutions, the absence of standardised terms in OTC derivatives poses challenges in terms of transparency and liquidity. Additionally, the lack of a centralised clearing house exposes counterparties to heightened credit risk, as there is no entity guaranteeing the fulfilment of contractual obligations.

In summary, OTC derivatives provide a flexible mechanism for managing risk and exposure, allowing counterparties to tailor contracts to their precise needs. However, this flexibility comes with inherent risks, including credit risk and potential liquidity constraints, underscoring the importance of thorough due diligence and risk management when engaging in OTC derivative transactions.

Exchange-Traded Derivatives

An exchange-traded derivative represents a financial contract listed and transacted on a regulated exchange, providing a structured and supervised environment for trading. Unlike over-the-counter (OTC) derivatives, exchange-traded derivatives offer several advantages, including standardisation, liquidity, and mitigation of default risk.

Among the most widely recognized exchange-traded derivatives are futures and options, which enable investors to hedge against risk exposure or speculate on various financial assets like commodities, equities, currencies, and interest rates.

These derivatives settle through a clearinghouse, such as the Options Clearing Corporation (OCC) or the Commodity Futures Trading Commission (CFTC), offering assurance and guarantee to market participants. This clearing process reduces investment risk by ensuring the fulfilment of contractual obligations.

Exchange-traded derivatives, including options and futures, are traded on regulated exchanges like the Chicago Mercantile Exchange (CME), International Securities Exchange (ISE), Intercontinental Exchange (ICE), and LIFFE exchange in London. This regulatory oversight and market structure enhance transparency and investor protection, making exchange-traded derivatives accessible to a broader range of investors, including retail traders.

One of the significant advantages of exchange-traded derivatives lies in their standardised terms and specifications, which simplify trading for investors. Standardisation enables investors to easily grasp crucial information about the contract, such as its value, quantity, and tradability. Moreover, exchange-traded derivatives offer flexibility in contract sizes, accommodating investors with varying capital levels through options like mini contracts.

Furthermore, exchange-traded derivatives mitigate default risk by having the exchange serve as the counterparty to every transaction. This arrangement ensures that counterparties fulfil their obligations, eliminating concerns about defaulting on contractual commitments.

Another distinctive feature of exchange-traded derivatives is their mark-to-market mechanism, where gains and losses are calculated daily. This daily valuation ensures that investors maintain sufficient capital to cover potential losses, preventing adverse impacts on market stability.

In essence, exchange-traded derivatives provide a regulated, standardised, and transparent marketplace for investors to manage risk, speculate on market movements, and optimise their investment strategies, thereby contributing to the efficiency and integrity of the global financial system.

Types of Derivatives

The most common types of derivatives include futures, forwards, swaps, and options, each serving distinct purposes in managing risk and optimising investment strategies. Below we will delve into the details of several key categories of derivatives.

CFDs

One of the most popular forms of derivatives among traders worldwide are contracts for difference or CFDs. CFDs offer exposure to diverse financial assets without actual ownership. Essentially, CFDs track the prices of global financial markets, allowing investors to speculate on price movements without directly owning the underlying asset.

Originating in the 1990s, CFDs were initially utilised by hedge funds and later became accessible to retail clients through online trading platforms. Today, companies like Plus500 offer CFD trading services across various markets, including indices, stocks, and forex, via intuitive online platforms.

In CFD trading, parties enter into agreements with brokers to trade the difference in the price of an underlying financial instrument from the contract's opening to its closure. Traders speculate on price movements, aiming to profit from accurate predictions while potentially incurring losses if market movements go against them.

Notably, traders can "go long" by opening Buy CFD positions or "go short" by opening Sell CFD positions, allowing them to profit from both upward and downward price movements without owning the underlying asset. CFD trading offers advantages such as low minimum deposits, no storage costs, and the ability to short sell.

However, CFD trading involves inherent risks, including market volatility and leverage. Leveraged trading amplifies both potential gains and losses, requiring traders to maintain adequate margin levels to cover potential losses. Margin requirements, comprising initial and maintenance margins, dictate the amount of capital needed to open and maintain CFD positions.

Despite the risks, CFD trading remains popular due to its flexibility and potential for profit. Traders should educate themselves on the complexities of CFD trading and consider seeking professional advice to mitigate risks effectively. Plus500 offers free educational resources, including videos and articles, to empower traders with the knowledge needed to navigate the markets confidently.

Futures

Futures trading, often regarded as one of the oldest forms of trading, traces its roots back to ancient times, with historical evidence suggesting its presence in Japan's Dojima Rice Exchange in 1697. Futures contracts, the cornerstone of futures trading, entail agreements between two parties to buy or sell a financial asset, such as commodities, currencies, or indexes, at a predetermined price and time in the future.

In a Futures contract, one party agrees to buy the underlying asset, while the other commits to selling it at a specified future date and price, irrespective of prevailing market conditions. Notably, traders are not required to pay the full price of the asset upfront but instead must deposit a fraction known as the margin, which varies depending on the asset and other factors.

Futures markets serve as exchanges where participants engage in buying and selling underlying assets for future delivery. These markets offer access to a diverse array of global financial instruments, including commodities, forex, interest rates, and indices. The history of futures markets dates back centuries, with modern iterations emerging in 19th-century Chicago, notably through the Chicago Mercantile Exchange (CME), a leading futures exchange.

Today, prominent futures exchanges such as the New York Mercantile Exchange (NYMEX) and the Chicago Board of Trade (CBoT) play pivotal roles in facilitating futures trading. Platforms like Plus500* provide traders with access to major futures exchanges worldwide, including EUREX, NYMEX, and others.

Futures contracts are classified as derivative contracts, as their value derives from the underlying asset. Therefore, they are considered derivatives, allowing traders to speculate on price movements and hedge against risks associated with the underlying asset. Overall, futures trading offers traders a versatile platform to engage in diverse financial markets and manage their investment portfolios effectively.

*Futures trading is not offered by Plus500 in all jurisdictions.

Forwards

Forward contracts, also known as forwards, operate similarly to futures contracts but are exclusively traded over-the-counter rather than on exchanges. These contracts offer buyers and sellers the flexibility to customise terms, sizes, and settlement processes to suit their specific needs, unlike standardised futures contracts. However, this customisation also introduces a higher level of counterparty risk due to the absence of exchange oversight.

Counterparty risk poses a significant concern in forward contracts, representing the risk that one party may fail to fulfil its obligations outlined in the contract. In the event of insolvency or default by one party, the other party may incur losses or be unable to enforce the terms of the contract.

Additionally, once established, parties in a forward contract have the option to offset their positions with other counterparties. While this flexibility provides opportunities for risk management, it also increases the complexity and potential for counterparty risks as more traders become involved in the same contract.

All in all, forward contracts offer customization and flexibility but come with inherent counterparty risks, making thorough risk assessment and management essential for participants in over-the-counter derivative markets.

Swaps

A swap is a type of financial derivative agreement in which two parties exchange cash flows or liabilities associated with different financial instruments. Typically, swaps involve cash flows linked to a notional principal amount, such as a loan or bond, although the underlying instrument can vary widely. Importantly, the principal amount itself usually remains unchanged throughout the swap agreement.

In a swap, each cash flow represents a leg of the contract. One leg of the swap typically involves fixed cash flows, while the other leg involves variable cash flows tied to factors like benchmark interest rates, floating currency exchange rates, or index prices.

Among the various types of swaps, interest rate swaps are the most common. Unlike standardised derivatives traded on exchanges, swaps are customised contracts negotiated over-the-counter (OTC) between businesses or financial institutions. Retail investors generally do not participate in swap transactions due to their complexity and tailored nature, which are better suited to the specific needs of the parties involved.

Options

An option represents a financial instrument linked to the value of underlying securities like stocks, indexes, or exchange-traded funds (ETFs). Unlike futures contracts, options offer buyers the choice to either buy or sell the underlying asset, depending on the type of contract held, without being obligated to do so. Each option contract comes with a predetermined expiration date, by which the holder must decide whether to exercise their option.

The specified price at which the asset can be bought or sold is known as the strike price. Options are typically traded through online or retail brokers. Options provide buyers with the right, but not the obligation, to buy or sell an underlying asset at a predetermined price and date. Call options and put options are the foundation of various option strategies designed for hedging, generating income, or speculative purposes. Options trading can serve both hedging and speculative objectives, offering a spectrum of strategies ranging from simple to intricate.

Derivatives: Advantages & Risks

As with any part of the financial markets, derivatives as a class come with their own unique set of plusses and drawbacks.

Advantages of Derivatives

• Price Lock-In: Derivatives offer the ability to lock in prices, allowing businesses to secure future transaction prices and reduce exposure to price fluctuations in underlying assets.


• Effective Hedging: Derivatives serve as effective hedging instruments, enabling stakeholders to protect themselves against adverse movements in interest rates, currencies, or other market variables, thereby minimising financial risks.


• Risk Mitigation: Derivatives provide a mechanism for mitigating risks associated with market volatility, offering a layer of financial security against unpredictable market conditions.


• Cost-Effectiveness: Despite their risk management benefits, derivatives often come at a relatively limited cost, making them an attractive option for businesses seeking efficient risk management strategies.


• Margin Trading: Derivatives can typically be purchased on margin, allowing traders to leverage “borrowed funds” for trading activities, thereby potentially enhancing cost-effectiveness and amplifying returns.

Disadvantages of Derivatives

• Valuation Challenges: One of the primary drawbacks of derivatives is the difficulty in accurately valuing them, as their prices are based on the performance of underlying assets, making their valuation complex and uncertain.


• Counterparty Risks: Over-the-counter (OTC) derivatives entail counterparty risks that are challenging to predict or evaluate, potentially exposing parties to financial losses if the counterparty defaults on its obligations.


• Market Sensitivity: Derivatives are sensitive to various market factors, including changes in expiration time, holding costs of underlying assets, and interest rates, making it difficult to match derivative values with underlying assets accurately.


• Intrinsic Value Vulnerability: Derivatives lack intrinsic value and are vulnerable to market sentiment and risk, leading to fluctuations in prices and liquidity unrelated to underlying asset performance.


• Leverage Risks: Derivatives are typically leveraged instruments, offering potential for higher returns but also amplifying losses, making them susceptible to rapid and substantial declines in value, especially in volatile market conditions.

How to Trade Derivatives With Plus500

Getting started with trading Contracts for Difference (CFDs) on Plus500 is straightforward and can be accomplished in just a few simple steps. Follow these steps to begin your CFD trading journey:

1. Select Your CFD Trading Method:
   Determine the type of CFDs you wish to trade on Plus500's platform. Plus500 offers a diverse range of CFD products, including stocks, indices, commodities, forex, and options. Consider your investment goals, risk tolerance, and market knowledge when choosing the CFDs you want to trade.


2. Familiarise Yourself with the CFD Market:
   Before diving into CFD trading, take the time to educate yourself about the CFD market. Learn about the different types of CFDs available, market news, trading strategies, and risk management techniques. Plus500 provides educational resources, including articles, videos, and tutorials, to help you gain a deeper understanding of CFD trading and inherent risks.


3. Open and Verify Your Plus500 Account:
   To start trading CFDs on Plus500, you'll need to open an account and verify your identity. The account opening process is quick and straightforward, requiring you to provide basic personal information and adhere to Plus500's verification procedures. Once your account is verified, you can deposit funds and begin trading CFDs.


4. Develop Your CFD Trading Strategy:
   Before executing your first CFD trade, develop a comprehensive trading strategy tailored to your financial goals and risk tolerance. Consider factors such as entry and exit points, position sizing, leverage usage, and risk management techniques. A well-defined trading strategy can help you make informed decisions and navigate the volatile CFD market effectively.


5. Start Trading CFDs:
   Once you've chosen your preferred CFD trading method, familiarised yourself with the market, opened and verified your Plus500 account, and developed your trading strategy, it's time to start trading! Log in to your Plus500 account, navigate to the trading platform, and execute your CFD trades based on your established strategy. Monitor your trades closely, adapt to market conditions, and continue learning and refining your trading approach for long-term success.

Conclusion

In conclusion, financial derivatives represent a multifaceted ecosystem of instruments designed to manage risk, speculate on market movements, and optimise investment strategies. While derivatives offer numerous advantages, including price lock-in, effective hedging, and cost-effectiveness, they also entail inherent risks, such as valuation challenges, counterparty risks, and market sensitivity.

Despite these drawbacks, derivatives remain integral to modern finance, providing investors with indispensable tools to navigate the dynamic and complex landscape of global financial markets. Whether trading futures, options, swaps, or contracts for difference (CFDs), thorough understanding, diligent risk management, and continuous learning are essential for success in derivative trading.

Plus500 offers a user-friendly platform for trading CFDs, empowering traders to capitalise on market opportunities while managing risks effectively. By following the outlined steps, traders can embark on their CFD trading journey with confidence, leveraging the flexibility and potential of derivative instruments to achieve their financial goals.

FAQs

Are CFDs considered derivatives?

Yes, CFDs (Contracts for Difference) are considered derivatives.

What are the main types of financial derivatives?

The main types of financial derivatives include futures, options, swaps, and contracts for difference (CFDs), among others.

What types of underlying markets have financial derivatives?

Financial derivatives are based on a variety of underlying markets, including stocks, bonds, commodities, currencies, interest rates, and market indexes.

Are derivatives leveraged?

Yes, derivatives often involve leverage, amplifying both potential gains and losses.

Where can I trade derivatives?

Derivatives can be traded on various platforms, including exchanges like the Chicago Mercantile Exchange (CME) and online trading platforms like Plus500.

What are some examples of derivatives?

Examples of derivatives include futures contracts, options contracts, swaps, and contracts for difference (CFDs).