What Is A Derivative?

Within the fields of trading and finance, a derivative is considered to be an instrument used for investment via a contract. Its value is "derived" from (or based upon) that of another asset, typically referred to as the underlying asset or simply "the underlying." In other words, a derivative contract is an agreement that allows for the possibility to purchase or sell some other type of financial instrument or non-financial asset. Common types of derivative contracts include options, forwards, futures and swaps.

Among the many types of underlying assets that are commonly used with derivatives include equities or equity indices, fixed-income securities, currencies, commodities, credit events and even other types of derivatives. Derivative contracts are typically used by investors for the purpose of speculating, or hedging, against possible future changes in market factors, and thus against the future market value of an underlying asset.

The special value of derivatives contracts compared to contracts for direct trade of underlying assets is that they allow transference of risks from individuals or entities less willing or able to manage them to those more willing or able to manage them. Also, derivatives contracts often require only small or even no initial monetary investment, and they're settled at a future date from the buyers' and sellers' adherence to the contract.

Derivatives are subject to "net settlement" through delivery, or non-delivery, of the underlying asset. However, positions in transactions involving derivatives contracts are frequently closed before an underlying asset is delivered to a buyer.[1]

Common Derivative Attributes

The global derivatives market is a diverse arena that comprises many unique products. Regardless of asset class, derivatives are renowned for sharing three characteristics: liquidity, volatility and leverage.

1. Liquidity

Although not a universal fact, most derivatives markets feature robust liquidity. Forex pairs, futures contracts, and options are popular derivatives that attract an abundance of participants on a daily basis. However, depth of market does vary according to the instrument being traded.

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For instance, E-mini S&P 500 futures normally trade more volumes than E-mini DOW futures. Also, the EUR/USD regularly features a market depth vastly greater than that of other major, minor, or cross pairs. The more robust trading volumes, the greater the market depth and aggregate liquidity.

Market depth can be a challenge to quantify in the OTC derivatives markets. In an OTC setting such as the forex marketplace, reported trading volumes originate from liquidity providers or brokerage services. Conversely, standardised exchanges such as the NYSE, CME, or Euronext record the exact number of traded futures and options contracts.

Before trading any derivative financial contracts, a participant is well-advised to monitor the market depth and relative liquidity of the target product. Generally, products with strong market depth offer tight bid/ask spreads and reduced slippage; products with sparse liquidity feature enhanced slippage and wide bid/ask spreads.

Volatility

Volatility is one of the premier calling cards of derivatives. Volatility is the magnitude of asset pricing fluctuations over time. It's important to remember that derivatives are leveraged instruments based on the price of the underlying asset; due to this leverage, a derivative's price movement can be swift and dramatic.

To active traders, volatility is viewed as being a positive market attribute. For instance, stock market volatility gives short-term participants an array of swing trading, day trading and scalping opportunities facing the equities market indexes.

Derivatives furnish traders with consistent volatility, which can generate attractive trade setups. When coupled with enhanced leverage, financial derivatives are useful in hedging and speculative strategies.

Leverage

Financial leverage is the application of credit to facilitate an investment. In active trading, leverage affords the trader purchasing power via borrowed equity. This is done by posting a good-faith deposit with the broker known as margin. Derivatives products offer participants a multitude of leverage options, ranging from minimal to extreme.

Degrees of derivatives leverage vary according to product, market and brokerage service. For instance, forex leverage can be upwards of 50:1 (2% margin) or 100:1 (1% margin). Conversely, US stocks are traded with much lower 2:1 (50% margin) overnight or 4:1 (25% margin) intraday leverage.[3]

When trading derivatives, leverage is a major consideration. It is the proverbial "double-edged sword" as it boosts profit potential while simultaneously increasing risk. Highly leveraged positions are greatly impacted by any move in market price; the effect is exponentially reduced for modestly leveraged positions.

Although derivatives leverage may appear attractive, it is best applied prudently within the framework of a comprehensive trading plan.

Use Of Derivatives In Forex Trading

Much of currency trading is done on what is called the spot, or "cash," market where currency pairs are bought and sold at their present value and delivered within a two-day period. The period is based on the time for the transaction to clear in the accounts of the respective participants in the trade. Currencies, however, are commonly traded as part of derivative contracts in futures, forwards, options and swaps.[2]

Let's now take a look at the different types of derivatives in forex trading.

1. Futures Contract

A futures contract is an agreement to buy or sell a quantity of a currency at a pre-established price on a particular date in the future. Profits and losses on a futures contract are realised and paid out at the end of each day. The ongoing settlement structure is beneficial to traders with the goal of generating normalised cash flows.

Currency futures contracts are traded in standard sizes and have set maturity dates, generally falling on the third Wednesday of March, June, September and December. Participants in currency futures contracts can be "hedgers" seeking to lock in a price to diminish the risk of a future price change, or they can be "speculators" who enter into a trade seeking potential gains.

Standardised futures exchanges list currency futures contracts for public trade. The largest such vendor is the Chicago Mercantile Exchange (CME), which offers a lineup of FX futures contracts. Popular contracts are based on the euro, Japanese yen, Swiss franc, British pound and Canadian dollar. Transactions on the exchange are regulated and guaranteed, mitigating counterparty risk.

2. Forward Contract

Like a futures contract, a forward contract is an agreement to buy or sell a quantity of a currency at a pre-established price on a particular date in the future. Differently from a futures contract, however, profits and losses on a forward contract are realised and paid out only when the contract expires.

Forward contracts are traded on an over-the-counter basis between two parties, and unlike futures contracts, these are not regularly bought and sold on exchanges.

3. Option Contract

A currency option gives an investor the right, but not the obligation, to buy or sell a quantity of currency at a pre-established price on or before the date that the option expires. The right to sell a currency is known as a "call option" and the right to buy is known as a "put option."

Options can be understood as a type of insurance where buyers or sellers can take advantage of more favourable prices should market conditions change after the option is purchased. They are cost effective as the only up-front financial liability is the option's premium.

Buying a call option, for example, can be used as insurance against the risk of a rising exchange rate, whereas buying a put option can be used against the risk of a falling exchange rate. Depending on the differential between market price and the option's strike price, the contract expires with a monetary value or worthless.

Options are traded on both the over-the-counter market and also on exchanges. In addition to use as a means to buy or sell currency, options can also be used to buy or sell other derivatives such as futures.

4. Swap Contract

A currency swap is an agreement between two parties to exchange flows of payments in two different currencies on different dates. Participants in currency swap agreements typically seek to exchange the terms of interest repayments available to the respective counter-parties to the agreement.

The payment flows are based on the exchange, or "swap," of a defined amount known as the principal, or notional, amount. Often one party to the agreement will seek a fixed-rate interest payment at a steady yield while the other party seeks a floating-rate payment that could offer an opportunity for an improving yield.

Summary

According to the United States Securities and Exchange Commission (SEC), a derivative is "a financial instrument whose performance is derived, at least in part, from the performance of an underlying asset, security or index."[4] In other terms, a derivative is a tradable product that is based on the value of a separate asset or asset class.

Derivatives have three primary features: liquidity, volatility and leverage. Each attribute is attractive to speculators and hedgers alike. When traded within the context of a comprehensive strategy, derivatives can aid in the achievement of nearly any financial objective.

FAQs

The following are the most frequently asked questions related to derivatives and derivatives products.

Why Do People Trade Derivatives?

Individuals trade derivatives to achieve a range of financial objectives or goals. For speculators, many derivative products offer the volatility, liquidity and leverage ideal for a multitude of trading strategies. Scalpers, day traders and swing traders frequently target forex and futures products for this reason.

On the other hand, hedgers buy and sell derivatives to manage risk. This is common practice in portfolio management as well as for producers such as farmers or logistics companies.

What Are Credit Default Swaps?

The U.S. Federal Reserve defines credit default swaps (CDS) as follows:

"Financial instruments that allow the transfer of credit risk among market participants, potentially facilitating greater efficiency in the pricing and distribution of credit risk."[5]

Pragmatically, a CDS is a contract where one party pays a premium over time to secure a payout in the event of a counterparty debt default. In this way, credit default swaps are often thought of as financial insurance policies. Institutional investors such as banks, pension funds and insurance companies often purchase CDS contracts to hedge counterparty risk exposure.

What Is The Difference Between European And American Options?

Although similar, American and European options contracts have one primary difference. American options may be exercised at any time ahead of expiry; European options can only be exercised on the contract's expiration date.

What Are Shares CFDs?

A share contract-for-difference (CFD) is a derivative based on the stock price of an individual company. These products furnish traders and investors with the ability to select isolated stocks for purchase or sale. Given the specificity, many traders view shares CFDs as being well-suited for speculative or hedging strategies.

Shares CFDs are based on a broad cross section of companies from around the globe. A few of the most heavily traded are Google (GOOGL), Facebook (META), Netflix (NFLX) and Ford (F).

FXCM Research Team

FXCM Research Team consists of a number of FXCM's Market and Product Specialists.

Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.

References

1

Retrieved 27 Nov 2015 https://www.bis.org/ifc/publ/ifcb35a.pdf

2

Retrieved 27 Nov 2015 https://www.phil.frb.org/research-and-data/publications/business-review/1995/brmj95gh.pdf

3

Retrieved 23 Jun 2022 https://www.thebalance.com/day-trading-restrictions-on-us-stocks-103135

4

Retrieved 23 Jun 2022 https://www.investor.gov/introduction-investing/investing-basics/glossary/derivatives

5

Retrieved 23 Jun 2022 https://www.federalreserve.gov/econres/feds/files/2022023pap.pdf

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