Derivative is one of the instruments used by traders to invest via contract. Derivatives are considered controversial on some point, because of the risks they bare and their usage in hedging, etc.
What is derivative
Derivative is an agreement or contract that allows parties to obtain the right or undertake to perform certain actions with respect to the underlying asset. Usually derivatives provide the opportunities to buy, sell, grand or receive a certain asset.
In general, the main purpose of derivatives is not to actually obtain the underlying asset, but to hedge price or currency risk over time, or to profit speculatively from changes in the price of the underlying asset. The result for each party can be either positive or negative.
A distinctive feature of derivatives is that the total number of obligations on them is not related to the total amount of the underlying asset traded on the market. For example, the total number of CFD contracts for shares of a company can be several times bigger than the number of issued shares.
Characteristics of the derivative
Derivative has 3 main characteristics.
- Derivative’s price is changing after the price of the underlying asset has changed;
- Derivatives require relatively small initial investment in comparison to other similar instruments;
- The calculations on derivatives are performed in the future.
Typed of derivatives
The underlying asset can be almost anything: securities, currencies, interest rates, inflation levels, official statistics, etc.
Futures contract supposes that the buyer and seller agree to buy or sell a certain quantity of currency or another asset at the certain established price. The whole idea is that this deal has to be fulfilled on a particular date in the future. The parties are liable to the exchange until the execution of the futures.
Swap contracts are used between two parties as a combination of two opposite conversion transactions for the same amount with different value dates.
Option contract is a contract in which the buyer of an option (potential buyer or potential seller of an underlying asset) has the right, but not the obligation, to buy or sell the asset at a pre-determined price at a future point or over a specified period of time. In this case, the seller of the option is obliged to sell the asset or buy it from the buyer of the option on their terms.
Therefore, CFD, futures, options, binary options, swaps, forwards, warrants, credit default swaps and others – all of those are considered to be derivative contracts.
Use of derivatives
Derivatives are widely used in hedging. Traders also use them to decrease the risks in the underlying asset. To do so, traders enter the derivative contract of a values opposite to the underlying position. Therefore, part of the underlying asset’s position cancels out.
Derivatives are used to provide leverage to ensure that a small movement of the underlying asset causes a significant change in the value of the derivative.
The reason why some derivatives are considered controversial is that they are also used in speculations for profit when the value of the underlying asset moves in the expected direction. Be careful when using options and other kinds of derivatives to make sure you don’t obtain the unexpected losses.
2020-07-23 • Updated