Financial Derivatives

Financial Derivatives
What are financial derivatives?

Financial Derivatives trading

Derivative contracts are commonly used by the majority of the world’s largest companies, so they can better manage their risk and make their cash flow more steady and predictable. This level of predictability in cash flow and earnings can help boost their stock price. When their price is boosted, they need less working capital.
Derivatives work on a small premium, so a company need not have a large amount of cash on hand to invest. Often before the contract has expired, another contract is opened to offset the first.

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What is a Financial Derivative?

Quite simply, a financial derivative is a security, that forms a contract between two or more parties. These types of contracts are often based on asset classes like commodities (eg. Oil or Gold) and for currencies (like the EUR/USD). They are used for company stocks and even for interest rates.

Types of Derivatives:

The most common types of derivative contracts are futures, options and CFDs. These are offered either OTC (Over-the-counter) or via an Exchange. The derivative’s value is affected by the performance of the underlying asset and also the contract conditions.

The more common derivatives used in online trading are:

  • CFDs
    CFDs enable you to speculate on the increase or decrease in the price of global instruments like shares, currencies, indices and commodities. When you trade CFDs, you are effectively taking a contract, rather than taking hold of the underlying asset. That means you will be speculating on the price movement, rather than buying the actual asset. With CFDs, you can trade both ways, on both rising or falling markets. That is a big benefit of trading CFDs, rather than buying stocks, for instance.

  • Futures Contract

    This is often used for commodities, shares or currencies to offset risk. A company that needs to receive raw materials in the future, can have a reasonable price locked in. This will protect it from future price hikes.

    This may also protect a company from future currency exchange rate changes or even interest rate changes. This protects against currency depreciation, especially in terms of exporting products into the local currency.

    Index futures, like the S&P 500 E-mini Futures (ES) and also currencies, take on board current investor sentiment in order to reflect that into the future pricing, taking on board interest rates.

    The pricing of these contracts also changes based on the current supply and demand of the underlying asset and of the contracts themselves. They can be offset or liquidated before expiry.

    Futures are standardised to facilitate trading on the futures exchange such as the Nymex exchange for Gold.

  • Options
    Trading options on the derivatives markets gives traders the right to buy (CALL) or sell (PUT) an underlying asset at a specified price, on or before a certain date. The holder has no obligation to buy the underlying asset. This is the main difference between Options and Futures.

  • Futures vs. Options
    The purpose of both futures and options is to allow people to lock in prices in advance, before the actual trade. This enables traders to protect themselves from the risk of unfavourable prices changes. However, with futures contracts, the buyers are obligated to pay the amount specified at the agreed price when the due date arrives. With options, the buyer can decide to back out of the contract. This is a major difference between the two securities. Also, most futures markets are liquid, creating narrow bid-ask spreads, while options do not always have sufficient liquidity, especially for options that will only expire well into the future. Futures provide greater stability for trades, but they are also more rigid. Options provide less stability, but they are also a lot less rigid. So, if you would like to have the option to back out of the trade, you should consider options. If not, then you should consider futures.

  • Forward Contracts
    Financial instruments that are set up with more of an informal agreement and traded through a broker that offers traders the opportunity to buy and sell specific assets such as currencies. Here too a price is set and paid for on a future date. This contract can also be renegotiated, so extended or closed early for a premium.

  • Swaps
    Swaps are customised OTC contracts between two traders. These aren’t usually traded by retail investors and are not traded over exchanges. A common example of a swap is on interest rates. Swaps are when two parties exchange cash flows or liabilities for two different securities, over a set period of time.

Why Trade Financial Derivatives?

As mentioned earlier the main purpose of derivative contracts was to give companies a predictable cash flow and to offset their risk.

Nowadays, the main reason for derivatives trading is for speculation and for the purpose of hedging, as traders look to profit from the changing prices of the underlying assets, securities or indexes.

An example of a derivative used for hedging or minimising risk is when a trader tries to profit from a decrease in an assets selling price (sell position). When he inputs a derivative used as a hedge, it allows the risk associated with the price of the underlying asset to be transferred between both parties involved in the contract being traded.

Derivatives Trading with AvaTrade:

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We recommend you to visit our trading for beginners section for more articles on how to trade Forex and CFDs.

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