Derivatives Trading: Strategies and Useful indicators
Important Things To Know Before You Start Derivatives Trading
Have you ever wondered what is derivative market? What are the different types of derivatives? How to make money in the derivatives market and through many types of derivatives? You may know that derivatives are financial securities whose value or price is derived from an underlying asset or a group of assets. These assets can be stocks and currencies, among others. Both seasoned long-term investors and savvy short-term traders use different types of derivatives to either hedge portfolio or to gain from sharp movements in prices. Before you begin derivatives market trading, find out 10 important things you must know.
What is derivatives Market?
Derivatives market is a financial market for trading in derivatives which is widely used across the globe. Many people ask what is a derivative?. Derivatives are a useful financial instrument. By using different types of derivatives, you can remove the need to invest a large amount of capital upfront. A derivative allows you to benefit from market movements. If you are good at anticipating market movements, derivatives are a good friend since they allow you to ear returns quickly. They also double up as an effective tool to hedge risks. The classical derivative definition is A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset or set of assets. This is how many define derivative. Next, we will learn what are the advantages of trading in types of derivatives
Special Considerations
Derivatives were originally used to ensure balanced exchange rates for internationally traded goods. International traders needed a system to account for the differing values of national currencies.
Assume a European investor has investment accounts that are all denominated in euros (EUR). Let's say they purchase shares of a U.S. company through a U.S. exchange using U.S. dollars (USD). This means they are now exposed to exchange rate risk while holding that stock. Exchange rate risk is the threat that the value of the euro will increase in relation to the USD. If this happens, any profits the investor realizes upon selling the stock become less valuable when they are converted into euros.
A speculator who expects the euro to appreciate compared to the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not need to have a holding or portfolio presence in the underlying asset.
Many derivative instruments are leveraged, which means a small amount of capital is required to have an interest in a large amount of value in the underlying asset.
Types of Derivatives
Derivatives are now based on a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.
There are many different types of derivatives that can be used for risk management, speculation, and leveraging a position. The derivatives market is one that continues to grow, offering products to fit nearly any need or risk tolerance. The most common types of derivatives are futures, forwards, swaps, and options.
1. Futures
Futures are exchange organized contracts which determine the size, delivery time and price of a commodity. Futures can easily be traded because they are standardized by an exchange. Per commodity traded there are different aspects specified in a futures contract. First of all is the quality of a commodity. For a commodity to be traded on the exchange, it must meet the set requirements. Second is the size of a single contract. The size determines the units of a commodity that is traded per contract. Thirdly is the delivery date, which determines on which date or in which month the commodity must be delivered. Thanks to the standardization of futures commodities can easily be traded and give manufacturers access to large amounts of raw materials. They can buy their materials on the exchange and don’t need to worry about the producer or take on contracts with multiple suppliers.
2. Forwards
Forwards and futures are very similar as they are contracts which give access to a commodity at a determined price and time somewhere in the future. A forward distinguish itself from a future that it is traded between two parties directly without using an exchange. The absence of the exchange results in negotiable terms on delivery, size and price of the contract. In contrary to futures, forwards are usually executed on maturity because they are mostly use as insurance against adverse price movement and actual delivery of the commodity takes place. Whereas futures are widely employed by speculators who hope to gain profit by selling the contracts at a higher price and futures are therefore closed prior to maturity.
3.Cash Settlements of Futures
Not all futures contracts are settled at expiration by delivering the underlying asset. If both parties in a futures contract are speculating investors or traders, it is unlikely that either of them would want to make arrangements for the delivery of several barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing (unwinding) their contract before expiration with an offsetting contract.
Many derivatives are in fact cash-settled, which means that the gain or loss in the trade is simply an accounting cash flow to the trader's brokerage account. Futures contracts that are cash-settled include many interest rate futures, stock index futures, and more unusual instruments like volatility futures or weather futures.
4.Swaps
Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa.
Imagine that Company XYZ borrows $1,000,000 and pays a variable interest rate on the loan that is currently 6%. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encounter a lender that is reluctant to extend more credit while the company has this variable rate risk.
Assume XYZ creates a swap with Company QRS, which is willing to exchange the payments owed on the variable-rate loan for the payments owed on a fixed-rate loan of 7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the 1% difference between the two swap rates.
If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will have to pay Company QRS the 2% difference on the loan. If interest rates rise to 8%, then QRS would have to pay XYZ the 1% difference between the two swap rates. Regardless of how interest rates change, the swap has achieved XYZ's original objective of turning a variable-rate loan into a fixed-rate loan.
Swaps can also be constructed to exchange currency exchange rate risk or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular kind of derivative. In fact, they've been a bit too popular in the past. It was the counterparty risk of swaps like this that eventually spiraled into the credit crisis of 2008.
5.Options
An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset.
In terms of timing your right to buy or sell, it depends on the "style" of the option. An American option allows holders to exercise the option rights at any time before and including the day of expiration. A European option can be executed only on the day of expiration. Most stocks and exchange-traded funds have American-style options while equity indices, including the S&P 500, have European-style options.
Imagine an investor owns 100 shares of a stock worth $50 per share. They believe the stock's value will rise in the future. However, this investor is concerned about potential risks and decides to hedge their position with an option. The investor could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50 per share known as the strike price until a specific day in the future known as the expiration date.
Assume the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise their option and sell the stock for the original strike price of $50 per share. If the put option cost the investor $200 to purchase, then they have only lost the cost of the option because the strike price was equal to the price of the stock when they originally bought the put. A strategy like this is called a protective put because it hedges the stock's downside risk.
Alternatively, assume an investor doesn't own the stock currently worth $50 per share. They believe its value will rise over the next month. This investor could buy a call option that gives them the right to buy the stock for $50 before or at expiration. Assume this call option cost $200 and the stock rose to $60 before expiration. The buyer can now exercise their option and buy a stock worth $60 per share for the $50 strike price for an initial profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the cost of the option the premium and any brokerage commission fees.
In both examples, the sellers are obligated to fulfill their side of the contract if the buyers choose to exercise the contract. However, if a stock's price is above the strike price at expiration, the put will be worthless and the seller (the option writer) gets to keep the premium as the option expires. If the stock's price is below the strike price at expiration, the call will be worthless and the call seller will keep the premium.
Advantages of Derivatives
Unsurprisingly, derivatives exert a significant impact on modern finance because they provide numerous advantages to the financial markets:
1. Hedging risk exposure
Since the value of the derivatives is linked to the value of the underlying asset, the contracts are primarily used for hedging risks. For example, an investor may purchase a derivative contract whose value moves in the opposite direction to the value of an asset the investor owns. In this way, profits in the derivative contract may offset losses in the underlying asset.
2. Underlying asset price determination
Derivatives are frequently used to determine the price of the underlying asset. For example, the spot prices of the futures can serve as an approximation of a commodity price.
3. Market efficiency
It is considered that derivatives increase the efficiency of financial markets. By using derivative contracts, one can replicate the payoff of the assets. Therefore, the prices of the underlying asset and the associated derivative tend to be in equilibrium to avoid arbitrage opportunities.
4. Access to unavailable assets or markets
Derivatives can help organizations get access to otherwise unavailable assets or markets. By employing interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates available from direct borrowing.
Disadvantages of Derivatives
Despite the benefits that derivatives bring to the financial markets, the financial instruments come with some significant drawbacks.The drawbacks resulted in disastrous consequences during the Global Financial Crisis of 2007-2008.The rapid devaluation of mortgage-backed securities and credit-default swaps led to the collapse of financial institutions and securities around the world.
1. High risk
The high volatility of derivatives exposes them to potentially huge losses. The sophisticated design of the contracts makes the valuation extremely complicated or even impossible. Thus, they bear a high inherent risk.
2. Speculative features
Derivatives are widely regarded as a tool of speculation. Due to the extremely risky nature of derivatives and their unpredictable behavior, unreasonable speculation may lead to huge losses.
3. Counter-party risk
Although derivatives traded on the exchanges generally go through a thorough due diligence process, some of the contracts traded over-the-counter do not include a benchmark for due diligence. Thus, there is a possibility of counter-party default.
What Are the Main Benefits and Risks of Derivatives?
Derivatives can be a very convenient way to achieve financial goals. For example, a company that wants to hedge against its exposure to commodities can do so by buying or selling energy derivatives such as crude oil futures. Similarly, a company could hedge its currency risk by purchasing currency forward contracts.
Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares. The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to systemic risks.
Derivative trading strategies
With derivative trading, having a trading strategy is vital in deciding your entry and exit points. It is important to fix a plan that is built to achieve gains, limit losses and manage risk as much as possible.
Short-term traders such as day traders focus on following trends that arise throughout the day in short periods with the aim to gain from short-term price movements. There are several well-known strategies for short-term traders, such as scalping, which is where traders aim to make a profit from small price fluctuations, before and after executing a trade. Long-term trading involves holding on to a position for longer periods. Long-term traders make decisions based on fundamental analysis that mainly focuses on how the market will look in the future. Position trading is a popular long-term strategy, which enables traders to hold a position for a long period of time. Without concerning themselves with shorter-term trend movements, position traders’ focus is on the long-term objective.