DERIVATIVES
EXPLAINED

Derivatives are a fascinating facet of the financial markets, offering a way to trade on the future value of assets without necessarily owning them. They can be a powerful tool for investors looking to hedge risks or speculate on price movements. In this article, we’ll explore what derivatives are, the different types available, how they are traded, and their pros and cons.

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The group of financial instruments called “derivatives” includes futures, options, swaps and forwards, which are financial contracts whose value is derived from the performance of underlying assets, such as stocks, bonds, commodities, currencies, interest rates, or market indices.

They are essentially agreements between two or more parties based on the future price of these underlying assets. The primary purpose of derivatives is to manage risk, but they can also be used for speculative purposes to capitalise on price movements.

Types of Derivatives

There are several types of derivatives, each serving different purposes and strategies in the financial markets. The main types include futures, options, swaps, and forwards. Each has its unique characteristics and uses.

Futures

Futures contracts are agreements to buy or sell an asset at a predetermined price at a specified time in the future. They are standardised and traded on exchanges, making them highly liquid and accessible to a wide range of investors.

Futures markets grew out of the need for producers of raw materials, and manufacturers who need raw materials, to guarantee an exchange at some time in the future – at a predetermined price. Their versatility means that futures are now commonly used for hedging risks and also for speculating outright on price movements.

Options

Options give the holder the right, but not the obligation, to buy or sell an asset at a specified price within a certain period. They have similar functionality to futures; but with options, there is no obligation to go through with the transaction when the contract expires – doing so is optional.

There are two types of options: calls and puts. Call options allow the purchase of an asset, while put options enable the sale. Options are versatile instruments used for hedging, income generation, and speculative strategies.

Swaps

Swaps are contracts in which two parties exchange cash flows or financial instruments over a set period. They are typically used to manage interest rate risk or currency exposure. The most common type is the interest rate swap, where parties exchange fixed interest payments for floating rates.

Forwards

Forwards are similar to futures, but are not standardised or traded on exchanges. They are customised contracts between two parties to buy or sell an asset at a specific price on a future date. Forwards are often used in currency and commodity markets.

Because trades in forwards rely on bespoke legal contracts to be drawn up, they tend to be used by institutional rather than retail investors.

How Are Derivatives Traded?

Derivatives can be traded on exchanges or over-the-counter (OTC). Exchange-traded derivatives, like futures and options, are standardised contracts with specified terms and conditions.

Exchange-traded derivatives offer transparency, liquidity, and reduced counterparty risk due to the involvement of clearinghouses. OTC derivatives, such as swaps and forwards, are privately negotiated between parties and offer more customisation but come with higher counterparty risk.

The trading of derivatives requires a solid understanding of the underlying assets, market conditions, and the specific characteristics of the derivative contracts. Traders often use derivatives to hedge against price fluctuations or to speculate on market movements, leveraging the potential for significant returns or losses.

Pros and cons of derivatives

Derivatives are powerful tools and have functionality which is appealing to many. Most of the pros and cons relating to their use relate to how they are used, as much as the intrinsic characteristics of the instruments.

Final thoughts

Derivatives markets grew out of the need to manage risk – so that producers and consumers of goods could carry out their day-to-day business and investors could hedge exposure. In more recent times, derivatives have been traded outright by speculators which involves a greater degree of risk.

Derivatives aren’t necessarily riskier than any other type of asset, but they are powerful tools with sometimes complex rules and generally involve using leverage. That means they need to be fully understood before being traded.

For further insights into trading derivatives, visit the eToro Academy.

FAQs

What is a cash-settled future?

A cash-settled future, also known as a cash future, is a futures contract where the contract is settled in cash based on the difference between the contract price and the spot price of the underlying asset at expiry. The underlying asset is not physically delivered upon expiry.

Cash-settled futures allow investors to speculate on price moves without risking entering into a contract which would result in an exchange of the underlying asset in physical form.

What is “rolling” of a futures contract?

Rolling a futures contract involves booking trades which switch your position from being in a future which is due to expire, and into one with an expiry date further into the future. Booking both trades allows you to continue to maintain exposure to the underlying asset.

What are out-of-the-money options?

Out of the money (OTM) options are option contracts whose strike price is not favourable relative to the current market price of the underlying asset. If you were to exercise the option immediately, the trade would not generate a profit. OTM options lack intrinsic value, but the “optionality” of the instrument means they still have some value, based on the chance that they may turn profitable if there is a favourable price move in the underlying asset before their expiry date.