Stocks vs derivatives: Which is right for you?

Providing fundamentally different ways to trade, stocks and derivatives offer investors a way of diversifying their portfolio. So, you'll often find that traders spread their investments across a mix of each.

While sometimes known as a secondary method of trading due to the relation to an underlying asset, derivatives offer a separate, unique way to trade via a variety of instruments. Meanwhile, stocks are often considered the traditional way to invest.

We'll examine the key differences between trading derivatives vs stocks and explore the various strategies that are often used.

Stocks and derivatives explained

Stocks, also known as equity or shares in specific companies, are bought, owned and traded by an investor. If you trade stocks directly, you own the underlying asset. It's possible to trade stocks and shares in both the long and short-term.

Trading derivatives involves speculating on the value of an asset at a future point in time and being able to buy or sell at a previously defined price. In this sense, because you don't own the underlying asset, a derivative can also be thought of as a type of contract. Derivatives can be traded across multiple investments such as forex and commodities.

Are stocks derivatives?

While you can trade a variety of stocks using derivatives, they are not the same entity. With derivatives, only the contract is being traded rather than the asset itself. This means you'll never actually own the stock.

Examples of derivatives in the stock market

Unlike when trading stocks directly, there are various ways to trade derivatives in the stock market. Each method is based on the premise that the asset's price movement determines its value, and that the contract has a stated settlement date.

We'll explore the types of derivatives in detail, discuss the concepts behind each one and look at how they work as speculation tools.

Contracts for difference (CFDs)

CFD trading consists of an agreement between a trader and a broker. With CFDs, you buy and sell a contract that imitates the underlying asset. CFDs don't have a fixed timescale. CFDs offer an exchange on the price difference, rather than a stake in the potential price movement.

Let's say you want to buy Mastercard (MA.us) CFDs at 341.9. You think that the value will increase so you buy 1,000. As predicted, the price movement rises to 351.9 so you sell at this and make a profit of £100. You can also go short with CFDs if you believe that the price of your given asset will fall.

But if the price movement goes in the opposite direction to your prediction, you'll lose the equivalent amount.

CFDs are leveraged so you can trade this derivative in the stock market with a lower margin. But, as mentioned before, this can also increase your losses should the trade not go in your favour.

Swaps

Swaps involve the exchange (or swap) of cash flow between two separate parties. Like other types of derivatives, swaps are based on an underlying asset with a monetary value and include currency swaps.

Usually, however, an interest rate swap takes place, exchanging a fixed rate for a floating rate, between two financial institutions without a broker involved. Each party will agree on the terms for a fixed period. This is more common between large parties such as individual countries and is often used in times of economic volatility to stabilise assets.

Due to the risk involved, these types of derivatives are not generally utilised by individual traders.

Options

A stock option is a derivative involving contracts that allow the trader to buy or sell at an agreed price within a set period.

For example, you might choose to buy a call option that allows you to buy Apple shares (AAPL.us) at 131.00 within a four-week time frame. If the price of the shares increases, you can buy at a reduced price and potentially make a profit. If the value decreases, there's no obligation to buy but you'll lose the initial premium you paid for your right to buy.

You can also choose to sell the market, giving someone else the right to buy from you or sell to you.

These are a popular way of trading, due to the flexibility (and perceived lower risk) that options offer.

The pros and cons of directly trading stocks vs derivatives

As with all types of trading, there are advantages and disadvantages to each method. Trading equity, as opposed to derivatives, means you own the asset and therefore the pros and cons will vary.

Advantages of trading equity

• No fixed time scales: You can usually place trades over both the long and short-term, enabling you to capitalise on your gains over months or years.
• Less volatile: Although all trading is subject to varying degrees of volatility, trading stocks directly is likely to offer a more stable foundation as you can trade over an extended period.

Disadvantages of trading equity

• No leverage: Direct equity trading means investing without leverage, so you'll gain access to a lower portion of the market.
• Minimal flexibility: Unlike derivatives, there's little flexibility on the trades you can make.
• Risk: All trading comes with some form of risk and investing in stock means you're liable to market sentiment, supply and demand, and other events outside of your control.

The pros and cons of trading derivatives in the stock market

Offering a different trading solution, derivatives also feature several advantages and disadvantages.

Advantages of trading derivatives

• Access to assets: Because you don't own the underlying asset, there is the potential for access to a wider range of assets that would otherwise be difficult, or inconvenient, to own.
• Flexibility: Unlike direct equity trading, there are many forms of derivatives that allow for greater flexibility and the option to go long or short.
• Leverage: As derivative trading often uses leverage, you could gain access to a larger portion of the market with a smaller deposit.
• Diversification: Trading derivatives in the stock market can offer a way to diversify your portfolio.

Disadvantages of trading derivatives

• Fixed periods: Derivatives generally have an expiration date, leaving little flexibility for longer-term investments.
• Leverage: While this can be a good thing, it also carries the risk of heavy losses depending on the outcome of your trade.
• High risk: Depending on how you trade, derivatives are often thought to be a high-risk strategy due to their basis in speculation and, with that, comes volatility.

Which is riskier, derivatives or stocks?

While it's impossible to give a concrete answer to which is the riskier form of trading, it's worth remembering that both strategies are reliant on how the market behaves as a whole. So, there's always some form of risk involved, whichever type of trading you choose.

You should always weigh up your options before making a decision and investigate the potential risks involved, especially if you're new to trading.

Stocks vs derivatives: Explore your options with FXCM

Wondering how to trade derivatives in the stock market? It's easy when you set up a CFD account with FXCM.

If you're new to trading, why not try your hand with a free demo account first? Then, when you're ready, take advantage of our all-in-one trading platform and customise your experience. It's simple to create an account and trade in a way that suits you.