What is Derivatives Trading?
Derivatives is a financial contract between two or more people based on (derived) the later price of an underlying asset that they are linked to. Derivatives trading can be done OTC (Over-The-Counter) or on a marketplace, such as the BitOrb exchange.
The assets that can be traded are most commonly:
- Market Indices
The earliest form of derivatives trading was proven around 600 BC by the Greek philosopher, Thales of Miletus. He was financially poor with limited resources at hand. With his knowledge of astronomy and meteorology observations, he speculated that the olive oil harvest will be good and secured the rights to the olive oil presses.
When the harvest turned out to be bountiful a year later, the demand for the presses grew which helped Thales to position himself to profit! The critical lesson is that his arrangement just gave him the right, but not the obligation, to hire the presses. If the harvest didn’t become a success, his losses were limited to only the deposit he paid.
Thus, the popularity of derivatives trading is comprehensible because it gives traders and investors the opportunity to trade without the actual need of buying them.
Today, the derivatives market has exponentially grown with the trading volume climbing up by 32% in May 2020 with a new record high of $602 billion. The derivatives market share rose to 33% in May compared to 27% in April 2020.
It gives traders and investors an opportunity to trade without the need of buying them.
5 Major Types of Derivatives
Derivatives is a growing market with many exchanges offering different products to meet the needs for different forms of risk managements and speculations.
Futures contract is an agreement between two parties for the purchase and delivery of an asset at a mutually agreed price in a future date.
The parties involved are obligated to fulfill the agreement to buy or sell the underlying asset by the expiry date.
Forward contracts are like futures contracts but they are only limited to OTC method – not on an exchange.
Perpetual contracts are similar to the futures contracts but do not have a settlement or expiration date. Hence, they are “perpetual” where it’s on-going.
Swaps refer to a type of exchange of one kind of cash flow or a variable attached with various assets with another. An example is using interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan (vice versa). Other forms of swaps are currency swaps and commodity swaps.
Options contracts, in the name itself, provides the traders the right and option to buy or sell the underlying asset at a specific date in the future at a mutually agreed price. The trader is not obliged to act upon their agreement.
There are two types of options:
- Call Option: You have the right but not the obligation to buy a given quantity of the asset at a given price.
- Put Option: You have a right but not the obligation to sell a given quantity of the asset at a given price.
Benefits of Derivatives Trading
- Lock in desired prices ahead of time
- Hedge against risks by making more than one investment where the risks can offset each other at jeopardy of any unfavourable price movements in the market
- Earn higher returns with the use of leverages (borrowed funds) which makes the trade cost less expensive
- Speculate on the price without having to trade the actual asset itself
Disadvantages of Derivatives Trading
- Due to the speculative features, there are higher risks on uncertain value of the asset
- Derivatives are highly sensitive to the supply and demand factors making the market highly volatile. Thus, traders must be proficient in technical analysis and fundamental analysis to limit their exposure to risks