Derivative Trading Guide for Beginners

Everybody knows that you can earn money on?currency?and?cryptocurrency?prices, invest money in securities, precious metals and resources. However, there is one more category – derivative financial instruments or derivatives. In this article, we will take a closer look at these instruments, the rules of how they are traded and how quickly it is possible to earn a profit on derivatives with minimum investment. This is more than real, as the modern derivatives markets are loyal to novice traders, and top brokers offer very good conditions for trading derivative financial instruments.

What are derivatives?

A derivative is not a currency, metal or commodity, nor is it a?share. It is a contract; a contract that implies that the seller and the buyer undertake to perform certain actions in regards to an asset, which is considered the underlying asset of this specific contract. Usually, the actions mean purchase or sale.

An example of a derivative: a futures contract for currency, let’s say the US dollars. Under this contract, the seller undertakes to sell to the buyer a certain quantity of dollars (for example for Euro) at a fixed price after an agreed-upon period. It does not matter which way the market price of the US Dollar changes at the time of the contract execution, because the asset will be sold strictly at the agreed-upon price.        

The derivatives are formal and standardized. Technically they are like securities; only the seller and the buyer are not obliged to own the underlying asset, and at least one of the parties has the right to sell the contract at any time.

Of course, the price of a derivative financial instrument always depends on the price of the underlying asset (for example, the price of a dollar futures contract depends on the market price of the US dollar). However, often these prices do not coincide, which allows traders to earn speculative profit.

To put it simply, derivatives allow traders to do two things at the exchange – to earn a profit on the change of the price of the underlying asset and hedge risks. We will discuss the earning opportunity below. Hedging the price or currency risk is opening positions in the same market to compensate for the risks in the other one. For example, a trader's key market is Forex, but in order to protect himself against the losses, he hedges the risk with a purchase – buys a futures contract on the traded currency, insuring himself against the supposed price growth.        

Hedging is a separate topic; today we will discuss how to earn a direct profit on derivatives. This is possible because the volume of rights and obligations for the derivative financial instrument does not depend on the quantity of the underlying asset in the market. The issuer (owner) of the derivative often does not own the asset. Let’s say, there may be much more CFDs on the bonds of a certain company than the securities themselves, because it is not the securities that are traded by their price difference in specific periods of time.

Basic features of a derivative

The price of the derivative instrument changes when the price of the underlying asset changes, but they are not always the same.
You need much less money to buy a derivative than to buy the underlying asset.
Calculations on the derivative are made in the future, not at the time of its purchase.:        

Notably, there are derivatives of derivative instruments, for example an option on the futures contract. Such derivatives have the same features and benefits of the original derivatives. The most important thing is that the derivatives market operates under the same laws of the commodities, securities and Forex markets. They have the same pricing rules and the same economic and political factors. Therefore, the price movement of derivatives can also be predicted.

Types of financial derivatives

Simply speaking, the derivatives can be divided into two groups: contract derivatives and freely traded derivatives. The prior are bilateral contracts traded over the counter and the latter are contracts that are traded at the exchanges, because they are standardized to fit them.

There is no common international law on derivatives; they are not even equated to securities in all countries. Therefore, when you trade these financial instruments, it is important to understand in which jurisdiction the broker that you are using to access the derivatives market operates. We will discuss the brokers later.        

There are quite many derivative financial instruments: futures and forward contracts, options contracts and issuer options, swaps, warrants, depositary receipts. There are several types of nearly each of these derivatives, for example there are futures contracts on supplies and settlements, and there are interest, Forex, commodity and asset swaps. Let’s take a closer look at the main types of derivative financial instruments.

Futures contracts

The simplest definition of a?futures contract?is that it is an obligation to perform a transaction on agreed terms. For example, under a Forex contract, the seller supplies USD 100 to the buyer at the price as of the moment the contract was concluded (right now). It does not matter what happened to the price over the week – the contract will still be executed on the agreed terms.

In regards to the securities, metals, and commodity contracts, the buyer does not become the owner of the asset, upon the expiration of the contract he receives the cost of the underlying asset. For example, a trader concluded a futures contract with another trader for the purchase of 10 shares of Meta in 2 months. At the time the contract was signed, the price of 1 share was USD 280, and the price of the contract – USD 28. Therefore, the current expenses of the buyer were 28x10 = USD 280.

Two months later, the price of 1 share of Meta grew to USD 340, but the transaction will still be executed at the initial contract price – USD 280 per 1 share. Therefore, the profit of the buyer will be: (340-280)х10-28х10= USD 320. His net profit will be this amount minus the broker’s fee. Meanwhile, the seller will close the trade at a loss: (340-280)х10 = USD 600. This is how all derivative financial instruments work – when one person makes a profit, the other one suffers a loss.

Forward contracts

The difference between forward contracts from futures contracts is primarily that they are traded over the counter. Therefore, they are not standardized and do not follow the rules of the exchanges. Forward contracts are often used by banks and other large financial organizations. The idea is that a forward contract allows you to level the expenses of exchanging one currency for the other.

For example, an importer (company A) takes out a loan in euros, but will have to repay it in US dollars at the current exchange rate. If euro price grows against the US dollar, the expenses of company A will increase. In order to avoid that, the company signs a forward contract with the exporter (company B), which benefits from the price growth of the foreign currency. Under the contract, company A purchases euros in the future at a specific fixed price, which is beneficial to both parties. This way, the contracting parties insure themselves against changes in the exchange rate.

Individuals can also conclude forward contracts, both financial (to buy currency) and commodity (to buy commodities). Example: a trader concludes a contract in the precious metals market for 3 months at the current price of platinum at $31 per 1 gram, undertaking to buy platinum at $35 per 1 gram after a specified period. Three months later, the platinum price increases to $40 per 1 gram, but the trader still buys it at $35. And then sells it immediately at $40. Therefore, a trader makes $5 per gram.

Options

An?option?as a derivative financial instrument is conceptually different from futures and forward contracts, as it gives not the obligation, but the right to conclude a transaction. If the buyer does not guess the trend right, he can refuse the transaction, while the seller will receive a compensation from the premium amount, which the buyer pays when he buys the option. At that, the seller is obliged to perform a transaction; he does not have the right to refuse. There are two types of such derivatives – put and call.

Put options allow the seller to sell the asset. For example, a share of a certain company costs USD 300. The buyer, who holds these shares, concludes an agreement with the seller, stating that in 6 months he will buy these shares at the stated price. The buyer transfers to the seller a premium of USD 50. After six months the shares price dropped to USD 230 – the buyer wins, because he paid only USD 50, but can now sell his shares at the price that is higher than the market price (USD 300).

If six months later, the shares price grew – the seller wins, because he buys the shares at a price that is lower than the market price and gets to keep the USD 50 premium.

Call options work the other way around – they give the right to buy the underlying asset. The buyer of an option still pays the USD 50 premium to the seller and has the right to buy the shares at USD 300 in six months (the stated price of the option). If the price grows within this timeframe (for example to USD 400), the buyer of the option uses his right and buys the shares at USD 300. If the price of the securities dropped, the buyer refuses the transaction and the seller keeps the premium.

Swaps

Swap?is a type of derivative that involves bilateral exchange of payments that is beneficial to both parties. There are interest and currency swaps. It is easier to review the currency swap. Let’s say that a large investor wants to buy bonds for USD 1 million. Under the conditions of the deal, in 1 year he will receive a profit of 5% of the amount, which is USD 50,000. It seems smooth, but the investor holds his funds in euros. They can be simply converted into US dollars, but this is often not expedient.

For example, an investor bought US dollars from a bank at the rate of 1.050. Therefore, for USD 1 million he paid EUR 952,000. And then, after 12 months, when he locked his profit – USD 50,000, he discovered that the US dollar dropped to 1.117. As a result, during the conversion into euros, he even suffered a loss (he received EUR 895,000). A swap is a good alternative.

Under the conditions of a swap, the bank offers the investor to buy USD 1 million at the rate of 1.050, which is EUR 952,000, and sell the same million in a year at 1.055, which is EUR 947,000. Plus USD 50,000 of profit, which the investor converts at the market rate in a year. In this case, the possible losses are minimized.

The most important thing is that with a swap, the investor rules out any risks. Of course, if the rate changes considerably in his favor, he could earn more without the swap, but there are no guarantees of that. This kind of risk is considered unreasonable.

Risks and opportunities for investors

Profitability of derivative trading is determined by several factors. The first one is the stated price. The second is the guarantee obligations, i.e. the premium, that protect the seller of the derivative in case the buyer refuses to buy. The third factor is that the derivative financial instruments are standardized and depend on the underlying asset; therefore they are predictable in the sense that the buyer of the derivative can successfully predict the movement of the asset’s price in the needed direction.

Finally, there is?leverage. Derivative trading through a broker implies the use of leverage, when a trader can enter into a trade for an amount that exceeds his investment. For example, leverage 1:5 indicates that a trader can conclude a futures contract for USD 100, while having only USD 20. Thanks to this, derivative trading has the huge profitability potential. Unfortunately, the risk indicator is high as well.

Risks of trading derivatives

Market risk. When the price of the underlying asset changes, one of the parties to the trade (seller or buy) always suffers a loss.
Credit risk. If the trade involves the use of leverage and the buyer refuses to buy, the seller will suffer a loss.
Liquidity risk. If the demand for the underlying asset drops, so does the?liquidity?of its derivative financial instruments.
Operational risk. Time difference (settlement time), delays and failures of technical systems, human factors – all of these can reduce the profitability of the trade and even lead to losses for any of the parties.:        

There are many risks and each can become critical for a trader. The market risk is the biggest one, when the forecast is wrong. In this case, a trader is guaranteed to suffer a loss and a big one, especially on leveraged trades. The same risk, however, determines the profitability of trading derivatives. As we’ve already mentioned, when one party to the trade loses money, the other one always earns a profit.

Risks of trading derivatives:

• Market risk. When the price of the underlying asset changes, one of the parties to the trade (seller or buy) always suffers a loss.
• Credit risk. If the trade involves the use of leverage and the buyer refuses to buy, the seller will suffer a loss.
• Liquidity risk. If the demand for the underlying asset drops, so does the?liquidity?of its derivative financial instruments.
• Operational risk. Time difference (settlement time), delays and failures of technical systems, human factors – all of these can reduce the profitability of the trade and even lead to losses for any of the parties.

How to start trading derivatives – a step-by-step guideStep 1. After reading this article, decide on the derivative financial instrument you would like to trade.

Step 2. Choose a broker that offers the best conditions for trading the chosen derivative (we will list the top brokers below).

Step 3. Register with the broker and pass verification. It is better to register via Traders Union in order to receive rebates.

Step 4. Make a deposit using the most convenient way for your (debit/credit card, wire transfer, electronic payment system). Start with a small amount of up to USD 100 (many brokers offer welcome bonuses).

Step 5. Select a specific instrument (for example a futures contract on dollar or an option for the shares of any company).

Step 6. Perform technical and fundamental analysis of the underlying asset of the chosen instrument and predict the change of its price.

Step 7. Buy the chosen derivative on the conditions that you’ve predicted and wait for its execution.

Step 8. If your forecast was correct, you will earn a profit; if not – you will suffer a loss.

Step 9. Use a demo account to test your strategy.

Step 10. Diversify your investment portfolio by buying different derivatives (and not only derivatives).

Step 11. Study educational materials and manuals on derivatives available on the broker’s website.

Step 12. Never stop, improve your theoretical knowledge and practical skills. Read books on derivatives and trade.

Best brokers to trade derivatives

It is safer, easier and more convenient to trade financial derivatives through licensed brokers that provide access to international markets and operate under the aegis of regulators. However, not all brokers offer equally beneficial conditions. Below, we will briefly review two platforms that TU’s users and experts ranked as the best.

InteractiveBrokers – the best choice for trading at the derivatives exchanges

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The broker provides access to the largest derivatives markets – the CBOE Futures Exchange, the Chicago Mercantile Exchange, CBOT, ENDEX, CME, ICE (U.S. futures and cryptocurrencies), the New York Stock and Mercantile Exchange, the Small Exchange SMFE. The minimum maintenance margin for futures is $50 per contract, for short options – $25/$50. The fees depend on the trading volume, for example, for options, beginners are charged with a fee of $0.25 per contract (IBKR Pro, $1 minimum order), while for standard futures, the exchange charges $0.85 per contract. The platform has its own educational program, free analytics, and additional services.