Derivatives trading explained: Exploring the main types of derivatives
Reading time: 6 minutes
Despite their reputation for complexity, derivatives are financial contracts whose value is derived from an underlying asset. That asset could be a stock, index, commodity, currency pair, bond, or even a cryptocurrency.
What are derivatives?
A derivative is a financial contract whose value depends on the performance of another asset. Rather than owning the underlying asset directly, traders enter into a contract whose value is linked to the asset's price movement. To give an example: instead of purchasing shares in a company outright, a trader might use a derivative contract that rises or falls in value in line with the company's share price.
Derivatives serve several purposes. Institutional investors often use them to manage risk, while retail traders commonly use them to speculate on short-term price movements. Because many derivatives offer leverage, traders can control larger positions with a smaller initial investment. However, leverage amplifies both profits and losses, making risk management a critical part of derivatives trading.
Why trade derivatives?
Derivatives remain popular because they offer flexibility that traditional investing may not provide. One advantage is the ability to potentially profit from falling markets. While investors typically benefit when asset prices rise, many derivative products allow traders to take short positions and potentially benefit from declining prices.
Another attraction is leverage. Rather than paying the full value of an asset, traders only need to commit a fraction of the position value as margin. This allows traders to gain larger market exposure with less upfront capital, although it also increases risk exposure.
Derivatives also provide access to a broad range of markets. Through a single trading account, traders may gain exposure to equities, indices, Forex, commodities, and fixed-income instruments.
Trading Contracts for Difference (CFDs)
A CFD is a contract between a trader and a broker to exchange the difference in an asset's price between the opening and closing of a trade. The trader never owns the underlying asset. Instead, they speculate purely on price movement.
CFDs are popular because they provide exposure to numerous markets through a single platform. A trader can move from trading gold to the FTSE 100, and then to major currency pairs, without needing to trade directly on multiple exchanges. The flexibility of CFDs also allows traders to go long when they expect prices to rise or short when they anticipate declines.
Successful CFD trading often involves technical analysis, disciplined risk management, and a clear understanding of leverage. Stop-loss orders and position sizing play particularly important roles in managing the risks associated with leveraged trading.
Trading Futures contracts
Futures contracts are standardised agreements to buy or sell an asset at a predetermined price on a specified future date. Originally developed for agricultural markets, futures now cover a vast range of assets including stock indices, oil, gold, natural gas, interest rates, and currencies. Unlike CFDs, futures contracts are traded on regulated exchanges. This standardisation helps improve transparency and liquidity.
Many traders use futures to speculate on short-term price movements. Others use them for hedging purposes. For example, an airline may use oil futures to manage fuel price risk, while an investor may use index futures to protect a stock portfolio during periods of market uncertainty.
One of the key considerations when trading futures is contract expiration. Traders must understand rollover procedures and settlement requirements to avoid unexpected obligations or outcomes.
Trading options
Options provide traders with the right, but not the obligation, to buy or sell an asset at a predetermined price before a specified expiration date. There are two main types of options: Call options provide the right to buy, while put options provide the right to sell.
What makes options unique is their versatility. Traders can use them for speculation, hedging, income generation, or portfolio protection. For example, a trader who expects a stock to rise may purchase a call option instead of buying the shares directly. This can provide similar market exposure while requiring less upfront capital.
Options trading introduces additional variables beyond simple price movement. Time decay, implied volatility, and strike price selection all influence an option's value. Because of these factors, options require a deeper understanding than many other derivatives. However, experienced traders often value the flexibility that options can offer.
Trading Forex derivatives
The foreign exchange (Forex) market is the largest financial market globally, with daily trading volumes measured in trillions of US dollars.
While spot Forex trading remains popular, many traders participate through derivative products such as CFDs, futures, and options. Forex derivatives allow traders to speculate on currency movements without exchanging physical currencies. Common examples include trading the EUR/USD, GBP/USD, and USD/JPY currency pairs.
Macroeconomic events often drive forex derivative markets. Interest rate decisions, inflation data, employment figures, and central bank commentary can all trigger significant price movements. Forex derivative traders often combine technical analysis with an understanding of economic fundamentals. Monitoring economic calendars and central bank communications is frequently just as important as analysing price charts.
Trading commodity derivatives
Commodity derivatives allow traders to gain exposure to raw materials without taking physical delivery of them. Popular commodity markets include gold, silver, crude oil, natural gas, wheat, coffee, and copper.
Commodity prices are often influenced by factors that differ from traditional financial markets. Weather conditions, geopolitical developments, supply disruptions, and changes in global demand can all affect pricing.
Gold derivatives, for instance, often attract traders during periods of economic uncertainty, while oil derivatives frequently react to geopolitical tensions and OPEC+ production decisions.
Commodity derivatives can provide diversification because commodity markets sometimes behave differently from stocks and bonds. However, commodity markets can also experience significant volatility, making risk management particularly important.
Trade derivatives with FP Markets
FP Markets provides traders with access to a wide range of derivative markets through CFDs, including forex, shares, indices, commodities, bonds, and cryptocurrencies. With competitive spreads, advanced trading platforms, fast execution, and flexible leverage options, traders can access the tools needed to implement a variety of derivatives trading strategies across global financial markets. Open an account with FP Markets today and start exploring the world of trading.
Frequently asked questions (FAQs)
When trading derivatives, you typically do not own the underlying asset. Instead, you trade a contract whose value is linked to the asset's price movements, allowing you to speculate on rising or falling markets.
The right market depends on your experience and trading goals. Many beginners start with CFDs because they provide access to multiple markets, but it's important to understand the product and practise on a demo account first.
Leverage can amplify both profits and losses, making derivatives riskier than some other investments. Using stop-loss orders, suitable position sizing, and a risk management plan can help manage these risks.
