Derivatives are financial instruments that you can find in the markets. They have grown in popularity ever since their original introduction to the world. But what are the derivative financial instruments about? Should you invest in them or should you avoid them? By reading this article you will find out some basic information on the subject above.
Derivatives 101
The derivatives are financial instruments that don’t hold a value of their own. Instead, they “leech” from other financial instruments like assets, or indices, or certain phenomena even. So, the value of the derivatives is directly dependent on the value of these other financial instruments.
The derivatives have their own purpose. They are put to use in scenarios when they are needed to decrease the business costs for a transaction. And sometimes they can be used to make profits. People use the derivatives because of necessity or because of simple willingness to use them.
There are certain risks that can be dealt with easily when using the derivative financial instruments. This is the practice called “hedging”. Hedging is done once the risk of one asset is transferred from one person to another, with the help of the derivative financial instruments.
You can also use derivatives for the purpose of speculation. This is not the use of derivatives for countering risks or for minimizing losses. It’s for the direct increase of profits. You can take full advantage of the rise of the value of the asset that underlies the derivatives. The result can be big profits.
Types of derivatives
There are two main types of derivatives: Exchange-Traded-Derivatives (ETDs) and Over-The-Counter derivatives (OTDs). This is the main classification of the derivative financial instruments. Based on this classification – there is another subclassification on three parts: swaps, options, and futures.
The futures are financial instruments that will enable you to buy an asset at a future date at the current price on the market. An example of an OTC derivative is a forward contract. An example of an ETD is a futures contract.
The options are contracts that will enable you to buy or sell an asset without it implying an obligation to sell and buy. The price of making this transaction is fixed and it’s called strike price.
The swaps are a type of contract that will enable you to exchange the underlying value of commodities, stocks, bonds, and currencies before a certain future date.
You could also use CFDs on shares, indices, and commodities. Indices trading involves the practice of traders that use the movements of the price of indices in order to make profits. The indices have no physical basis that you can trade on their own. So, if you wish to trade with indices, then you will need the support of derivatives such as CFDs.
A CFD, or contract for difference, is a contract made between an investment bank and an investor. The contract is about exchanging the difference between the closing and opening price of certain financial instruments.
The CFD trading of commodities is to be used for financial markets speculations. The commodities can be traded in two main forms, forward and cash. The delivery dates are the difference between them.
Finally, if you wish to trade Share CFDs, then you will be able to get access to a stock market of many companies. You will trade on the movements of the prices of shares of companies that trade in the equity market. The trader won’t need to own the underlying assets and this is a key distinction of trading CFDs. You won’t have to worry about bankruptcy or other potentially catastrophic events.
In conclusion
By now, you should have formed an understanding of what it means to deal with derivative financial instruments. There are a number of pros and cons when it comes to dealing with them. It will take a lot of time and effort before you will be able to say that you have mastered the subject of derivative financial instruments and that you will be able to make appropriate investments into them eventually.
