- Financial Derivatives trading
- What is a financial derivative?
- Derivatives Market
- Types of Derivatives
- Why trade financial derivatives?
- Derivatives trading with AvaTrade
- FCA Legislation and Financial Derivatives Trading
Financial Derivatives trading
With trading becoming more common and more accessible to everyone who has an interest in financial activities, it is important that information will be delivered in abundance and you will be well equipped to enter the global markets in confidence. Financial derivatives, also known as common derivatives, have been in the markets for a long time. Nowadays, online trading makes it easier to access them.
What is a financial derivative?
The easiest way to explain a derivative is that it is a contractual agreement where a base value is agreed upon by means of an underlying asset, security or index. There are many underlying assets that are contracted to various financial instruments such as stocks, currencies, commodities, bonds and interest rates.
A simpler definition of a derivative is that it is any security whose value is derived from the value of a different asset. There are a number of common derivatives which are frequently traded all across the world. Futures and options are examples of commonly traded derivatives. However, they are not the only types, and there are many other ones.
The derivatives market is extremely large. In fact, it is estimated to be roughly $1.2 quadrillion in size. The reason why it is so large is that there are derivatives available for many different assets including bonds, stocks, commodities, currencies, etc. Many investors prefer to buy derivatives rather than buying the underlying asset.
The derivatives market is divided into two categories: OTC derivatives and exchange-based derivatives. OTC, or over-the-counter derivatives, are derivatives that are not listed on exchanges and are traded directly between parties. Therese types are very popular amongst Investment banks.
Exchange-based derivatives are ones that are listed on exchanges, such as The Chicago Mercantile Exchange. It is common for large institutional investors to use OTC derivatives and for smaller individual investors to use exchange-based derivatives for trades. Clients, such as commercial banks, hedge funds, and government-sponsored enterprises frequently buy OTC derivatives from investment banks.
Types of Derivatives:
There are a number of financial derivatives that are offered either OTC (Over-the-counter) or via an Exchange. Derivatives values are affected by the performance of the underlying asset or, as mentioned, the contract.
The more common derivatives used in online trading are:
CFDs are highly popular among derivative trading, CFDs enable you to speculate on the increase or decrease in prices of global instruments that include shares, currencies, indices and commodities. CFDs are traded with an instrument that will mirror the movements of the underlying asset, where profits or losses are released as the asset moves in relation to the position the trader has taken.
Common derivatives based on an agreement to buy or sell assets such as commodities like sugar or shares paid for at a later stage but with a set price. Futures are standardized to facilitate trading on the futures exchange where the detail of the underlying asset is dependent on the quality and quantity of the commodity.
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 with no obligations this being the main difference between options and futures trading. Essentially, options are very similar to futures contracts. However, options are more flexible. This makes it preferable for many traders and investors.
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.
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 specified assets such as currencies. Here too a price is set and paid for on a future date.
Another common derivative used in a contract setting when trading are swaps, they allow both parties to exchange sequences of cash flows for a set amount of time. They are not exchanged or traded instruments but rather customized OTC contracts between two traders.
Why trade financial derivatives?
Originally derivatives were used to ensure there would be a harmonious balance in exchange rates for goods and services traded on a global scale. Traders found that with differences in currencies and accounting systems it would be easier for traders to find a common derivatives market.
Nowadays, the main reason for derivatives trading is for speculation and the purpose of hedging, as traders look to profit from the changing prices of the underlying assets, securities or indexes.
When a trader is speculating on derivatives, they can make a profit if their buy price is lower than the price of the underlying asset at the end of the futures contract. For example, if a person buys a futures contract for asset X, priced at $100, and if the price of asset X rises to $110 by the end of the contract, then the person made a profit of $10.
Derivatives come in several different forms, such as the kinds used for hedging or minimizing risk. For example, a trader may want 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.
However, even though derivatives are used for speculation, they are also used for risk management. Many parties use derivatives to make sure that they do not suffer from unfavourable price movements in the near future.
For example, cereal manufacturer may buy wheat futures at a certain price to make sure that the company will be able to afford to purchase the wheat a few months down the line. This protects the cereal manufacturer from being caught in a position where it cannot afford to buy the wheat it needs if the price of wheat rises too much in one month’s time.
Derivatives trading with AvaTrade:
Join AvaTrade today and benefit from the widest variety of financial derivatives that are on offer in our portfolio. Offering over 250 instruments that range from forex, CFDs for stocks, commodities and indices as well as currency options trading on a superior platform. We also support automated trading solutions.
Put into practice what you have learnt about financial derivatives without having to risk your own capital when you try our free 21-day demo account.
Traders can also enjoy maximum security as all clients funds are held in segregated accounts with international banks. In addition to that, platform safety is also a high priority on AvaTrade. All platforms are SSL encrypted for traders peace of mind.
FCA Legislation and Financial Derivatives Trading
In December 2020, United Kingdom implemented the G 20 decision to improve OTC derivatives markets by adopting the MiFIR (Markets in Financial Instruments Regulation) derivatives trading obligations according to the EU Withdrawal Act. The FCA embraced the agreement between the EU and the UK vis-a-vis their trade and cooperation agreement, and the attendant Joint Declaration on Financial Services Regulatory cooperation initiatives.
The agreement was a step towards avoiding disruption and fragmentation in the financial markets. The coordinated solution underscores the FCAs commitment to working with European Union authorities to avoid conflicts in the financial markets. The Financial Conduct Authority (FCA) put forth a series of rules regarding the prohibition of retail marketing, distribution, and sale of cryptoasset derivatives, and cryptoasset exchange traded notes on 06/01/2021.
The new rules are applicable to MiFID investment firms, excluding collective portfolio management investment firms. The regulations expressly state that the distribution or sale, and marketing of cryptoasset derivatives, including cryptoasset ETNs are expressly prohibited by any UK-based broker to any retail client. The firms include CRD credit institutions, as well as those providing investment services and/or activities to retail clients. According to the prohibitions set forth by the FCA, which AvaTrade UK fully complies with, brokerages are not allowed to sell cryptoasset derivatives, or cryptoasset ETNs (exchange traded notes) to retail clients.
According to the FCA, a retail client is defined as follows: ‘… A client is neither a professional client or an eligible counterparty or, any person who is advised by the firm on the merits of opening or buying a stakeholder product where the advice is given in the course of a business carried on by that firm, and it is received by a person not acting in the course of a business carried on by him, or a customer.’ The FCA has not banned cryptocurrencies themselves, only derivatives instruments for sale to retail customers have been banned. This includes, but is not limited to, the placement of speculative trades with contracts for difference (CFDs, futures, or options).
These types of trades can be harmful to retail traders who have little, or no experience with derivatives instruments. For the purposes of discussion, financial derivatives instruments have prices derived from other underlying financial instruments. In other words, they mirror the prices of other assets such as BTC, ETH, BCH, LTC, et cetera. With respect to the risks to retail traders, the FCA deems cryptocurrency too risky for inexperienced traders. Owing to the fact that financial derivatives can technically result in a trader owing more money than they invested, only professional traders are allowed to trade CFDs on crypto, and associated financial derivatives.
Financial Derivates main FAQs
- How are financial derivatives used?
The most common use for financial derivatives is to manage risk in a financial trade. While many think of risk reduction when managing risk is mentioned, it is also quite common for speculators to increase their risks (and potential profit or loss) through the use of financial derivatives. One common example is in the futures market where farmers will sell futures in order to lock in the price they will receive for their grain or livestock. This is a way to reduce risk. Another example is the use of CFD products for trading. Because of its leveraged nature a CFD can be used to magnify the results of trading in a wide variety of assets.
- What are some common types of financial derivatives?
There are a wide variety of financial derivatives that can be used to increase or decrease investment risks. One of the most common is the futures contract, which is an agreement on a future financial transaction on a set date and at a set price. Another type is a swap, where the agreement is to exchange one asset or liability for another. A third commonly used financial derivative is the option, which gives the holder the right, but not the obligation, to purchase or sell an asset at a future time. And finally, there is the contract for difference (CFD) which allows for the exchange of the difference in value of an asset between the time the contract is opened and closed, without owning the underlying asset.
- What types of underlying markets have financial derivatives?
Not only are there a wide variety of derivative types, there are also a wide variety of underlying markets that use financial derivatives. We commonly think of the derivatives of commodities, currencies, and equities, but that just touches the surface of financial derivatives. Other markets that use derivatives include the government bond market, short-term debt markets, over-the-counter lending markets, credit risk markets, and various index can also be used as the underlying for a derivatives contract.