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Beginners Guide to Derivative Trading and Derivative Market

Beginners Guide to Derivative Trading and Derivative Market
May 18, 2021 Tom Clark

Derivative trading has become dominant in the financial market since the 1980s and started from humble beginnings particularly centered on commodities like coffee and wheat. Since then, traders from all around the world started to get interested in derivatives and how to trade them.

The Derivative Market

The derivative market plays a very important role in the financial system. Derivatives are complex, but they strongly represent the practices in the modern-day period that has been going on for so many years. For instance, farmers agree on selling their crops ahead of time as insurance or even place bets against the other.

For retail traders, trading with a derivative paved the way to an array of markets that allows them to speculate on the price in the market, whether it rises or falls. But derivatives are complicated and need to be thoroughly understood. This is the only way to effectively trade in the market.

Derivative Market and Derivative Trading

According to the Collins English Dictionary, “A derivative is an investment that depends on the value of something else.” It is a contract that is not just between two parties but a lot, with a basis on the underlying asset. A derivative is mostly used to speculate on the movement of the market based on its underlying asset, without purchasing the asset itself.

There are a lot of assets that can be traded through derivatives. This includes commodities, interest rates, currencies, shares, bonds, and indices. In derivative trading, you can take short and long positions on stocks, which lets the trader speculate on the rise and fall of the prices in the future.

Trading Derivatives

There are two ways to trade on derivatives – over-the-counter (OTC) and regulated exchange. OTC derivatives allow traders to check contracts between the two parties involved. It is non-standardized and made in an unregulated market.

Regulated exchanges are more formal and show fewer risks than the previous way of trading. It is also standardized which means that there are low to nothing counterparty risks involved.

As for the derivative products, there are wide options to consider. But among the most used derivatives is the Contracts for Difference (CFD) and Options.

Contracts for Difference (CFD) involves a contract between the trader and the broker. The contract states that the difference, which is the price of the position during the opening and closing, will be paid by the losing party.

Types of Derivatives

You can trade different types of derivatives including Forward contracts, Futures contracts, options contracts, and swaps.

Forward Contracts

This type of derivative involves a buyer and a seller who both agree to trade the asset in the future time with the price that you have agreed to today.

Futures Contracts

This type of derivative evolves around forward contracts carrying a lot of the same characteristics. One unique aspect of Futures is that they are being traded in exchanges, meaning they are standardized and counterparty risks can be avoided.

Options Contracts

This derivative provides the right, not the obligation to buy and sell an asset on the agreed date in the future.