What are financial derivatives and how are they priced?
Derivatives trading is predicated on contractual agreements, based on the underlying value of an asset, index, or security. That serves as the base value of the contractual agreement. In derivative trading, there are scores of underlying financial instruments that are contracted to a multitude of financial instruments. These include interest rates, commodities, bonds, stocks, and currencies.
The simplest definition of derivatives is as follows: A security whose value is derived from the value of a different asset. Put differently, financial derivatives mirror the price activity of financial instruments that are traded in the markets. With derivatives, prices are derived from other financial assets.
There are plenty of common derivatives that are traded every day around the world.
A classic example of derivatives trading is futures, another is options. There are scores of other examples of derivatives trading options in the markets today. We will explore them in greater detail in this guide, courtesy of AvaTrade Australia.
- Derivatives Markets
- Different Types of Financial Derivatives
- What is Financial Derivatives Trading?
- Reasons to Trade Financial Derivatives
- Derivatives Trading Options at AvaTrade Australia
What is the derivatives market?
The derivatives market is massive. One cannot imagine the size of the derivatives market, but estimates have pegged it at approximately $1.2 quadrillion in size. That number is simply inconceivable and has grown since this figure was published.
It may seem extraordinarily hyper-inflated, but the derivatives market encompasses a multitude of financial instruments, including currencies, cryptocurrencies, commodities, stocks, bonds, ETFs, and many different asset classes.
Imagine a market that trades on price movements of every other market, and then some? The financial derivatives market is extremely popular because traders and investors actually prefer trading price movements, rather than owning the underlying asset.
With derivatives trading, profits can be generated in rising or falling markets. Derivatives are divided into two categories, namely over-the-counter derivatives (OTC), as well as exchange-based derivatives, at brokers, trading platforms, and via fund managers.
Financial derivatives listed as OTC, are not on any exchanges. These derivatives are exclusively traded between parties. There is no middle man involved. Investment banks tend to enjoy trading in OTC derivatives. Exchange-based derivatives trading – as its namesake suggests – are traded on exchanges. These include the CME (Chicago Mercantile Exchange).
Institutional traders tend to prefer OTC derivatives trading, while retail traders and investors tend to prefer exchange-based derivatives. Government-sponsored enterprises, commercial banks, and hedge funds typically buy over-the-counter derivatives from investment banks.
Different types of financial derivatives
Various types of financial derivatives are available to traders and investors. These are offered either OTC, or through an exchange. The value of derivatives is directly affected by the financial performance of the underlying financial instrument. This forms the basis of the contract. The most commonly traded derivatives online include the following:
- Contracts for Difference (CFDs)
CFDs rank among the most popular derivative trading instruments. A CFD enables you to speculate on prices – bullish or bearish – of financial instruments. These include commodities, currencies, indices, cryptocurrencies, shares, and the like. CFDs mirror the price movements of the underlying financial instruments a.k.a. financial assets.
Depending on the position that you take as a CFD trader, profits or losses can be generated accordingly. If you are bullish on a CFD and the price increases by the expiry time, you can profit. If you are bearish on a CFD, and the price decreases at expiry time, you can profit. These are the most accessible derivatives trading instruments at AvaTrade Australia.
- Futures Contracts
Futures contracts are commonly traded derivatives instruments where an agreement to buy or sell assets exists. These are usually commodities such as sugar, gold, or crude oil. Other futures contracts include shares a.k.a. equities.
The thing with futures is that payment is made at a later stage, at a set price. These financial derivatives are standardized to allow trading on the futures exchange. The underlying asset is wholly dependent on the quantity and quality of the commodity in question.
- Options Trading
Options trading on derivatives markets presents traders with benefits over traditional futures trading. With options trading, traders have the right to buy or the right to sell underlying assets at specified prices. The right to buy is known as a CALL option, and the right to sell is known as a PUT option.
These trades take place at a specified price, on/before a specified date. There are no obligations with options. While options and futures contracts are similar, options are inherently more flexible. That’s why they are preferred by investors and traders the world over.
- Futures Trading vs Options Trading
Whether you’re trading futures or options, the point of these trades is to lock in prices well ahead of the actual trade. In other words, traders have a preset figure in mind that is used to safeguard the trade in the event that prices move against the trade and make it unprofitable in the future.
Here is an example: Imagine you are buying crude oil for delivery next year. If you have a preset budget now and the price of oil increases next year, it could affect you adversely. By locking in prices ahead of time, you are guaranteed your price, irrespective of what happens in the markets. This protects traders against unfavorable price movements.
With futures contracts, however, the buyer is obligated to pay a specified amount at the agreed-upon price on the due date. Options are more flexible. The buyer is not obligated to pay the amount specified at the agreed-upon price. The buyer can effectively back out of the contract.
The majority of futures markets are highly liquid. This creates thin bid/ask spreads, while options don’t often have a lot of liquidity. This is especially true for options that expire well in the future. Futures as financial derivatives trading options, provide enhanced stability for trades. However, they are also inherently more rigid.
Options are less stable, but they are also less rigid. In essence, if you’re looking for an option to back out of the trade, always consider options. If you’re not looking to back out of the trade, consider futures.
- Forward Contracts
Forward contracts are financial derivatives that are established with an informal agreement and traded via a broker. The broker offers traders the option to buy and sell specified assets, such as forex. With forward contracts, a price is set and paid for on a future date.
Swaps are commonly traded derivatives contracts. Swaps allow both parties to the trade to exchange sequences of cash flows for a specified amount of time. They aren’t exchanged or traded instruments, but rather they are a customized ‘over-the-counter’ contract between the two parties to the trade.
What is financial derivatives trading?
The widespread liberalization of trading has facilitated easy access to anyone who is interested in financial activities. Derivatives trading instruments are a popular option available to traders across the board. The right information is sacrosanct when trading financial derivatives.
The derivatives market is a hive of activity, and accurate information is needed to forecast price movements. Fortunately, traders don’t need to reinvent the wheel with derivatives trading instruments – they’ve been around for eons. Now, you can trade financial derivatives online, right here at AvaTrade Australia.
Open your trading account and enjoy risk-free derivatives trading in demo mode!
Reasons to trade financial derivatives
The raison d’être for financial derivatives – at inception – was to ensure a balance in exchange rates for goods and services traded globally. Currency differences and accounting systems complicate international trade in the absence of a common derivatives market.
Today, most derivatives trading activity is done for speculative purposes, and for hedging. Hedging is mitigating against potential losses. Traders are always on the lookout for ways to profit from price changes of the underlying financial instruments, including commodities, stocks, bonds, indices, forex, and the like.
When traders speculated on financial derivatives, they can generate profits when the buy price is lower than the price of the underlying asset at the end of the futures contract. In other words, if the price is lower than the price at the expiry time. Assume a trader purchases a futures contract for asset XYZ, priced at AU$100. If the price of asset XYZ increases to AU$120, by the contract expiry, then the person has generated a profit of AU$10.
There are many different types of derivatives contracts. The derivatives trading instruments used for hedging a.k.a. mitigating risk are increasingly popular among traders and investors today. As a case in point, a trader may wish to profit from falling prices in an asset when that asset is sold. When the trader inputs a financial derivative, as a hedge, the attendant risk of that asset’s price reduction is transferred between both parties to the contract.
While speculative activity is common for derivatives, these financial instruments are also used for managing risk.
Consider the case of a mining operation that utilizes a specific commodity such as crude oil to ship its products abroad. The company wants to ensure that its pricing remains competitive in the future, even if oil prices increase sharply.
One way of implementing risk management is by way of futures contracts. The mining operation may purchase an oil futures contract at a specified price, to guard against unfavorable price movements in the future.
Derivatives trading options at AvaTrade Australia
Register an account to trade derivatives contracts such as CFDs at AvaTrade. Our derivatives trading platform is geared towards a wide range of financial derivatives, including some 250+ financial instruments. These cover a broad spectrum of the market such as indices, commodities, stocks, Forex, cryptocurrency, and other options in a CFD format.
Derivatives market trading via CFDs is wildly popular all over the world since traders do not have to purchase the underlying assets; it is possible to simply purchase that contract that mirrors the price movements of the underlying financial instruments. AvaTrade Australia also features automated trading, to facilitate smooth and seamless transactions with CFDs.
You can practice all that you have learned at AvaTrade, courtesy of a complimentary 21-day demo trading account. There is zero-risk of loss when trading CFDs on a demo account since none of your own capital is being used. At AvaTrade Australia, you have the added assurance of fully regulated trading, segregated accounts, and funds held with international banks.
AvaTrade Australia is fully licensed and regulated to offer CFD trading for multiple financial derivative trading instruments across the board. Safety and security are sacrosanct, with SSL encryption, regulation, firewall protection, username/password protection, and account verification protocols in effect.
Open an Account at AvaTrade Australia and Trade Derivatives in a Risk-Free Demo Account!
*Kindly consult our trading online for beginners guide for more info on how to trade currencies and CFDs