Why do some traders use derivatives instead of buying assets?
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If you want exposure to Apple (AAPL) or Nvidia (NVDA), do you buy these shares outright?
If you want exposure to oil, do you buy a barrel of oil?
What about gold? Would you buy physical gold and store it at home or in a vault?
These are the questions many newer investors ask. The reality is that you do not need to own any of these assets outright; you can simply trade derivatives to gain exposure to the asset’s price fluctuations.
What are derivatives?
The best way I can describe the majority of derivatives is simply as an agreement between two parties – a future buyer and future seller – that locks in and ‘guarantees’ a price. Each derivative contract specifies a future price (fixed at the time the trade is opened) at which an underlying asset will be bought by one party and sold by the other. Additionally, a derivative also specifies a future date at which the transaction will occur. This is not true for every derivative, but it is in most cases.
Suppose you want to invest in gold. Obviously, for many of us, the simplest way to do this is to buy physical gold and store it at home, and sell it when/if its value increases. But if you wanted to invest in large amounts of gold, not only would it be expensive, storage and security costs would need to be factored in.
To avoid these fees, you could trade gold derivatives. You open a trade for a standardised quantity of gold at a fixed price, and assuming you bought, you then sell it before the expiration date. If the current price is above (below) your original fixed price, you would have gained (lost) money on the investment. While there is more to it, this is a derivatives contract in a nutshell.
As you may have already guessed, a derivative's value is dependent on the underlying asset’s price. So, the core idea behind a derivative is that it represents a financial contract whose value is ‘derived’ from the underlying asset’s price, be it stocks, bonds, commodities, currencies, or even an index (although indices are a little more abstract).
The most common types are futures – which is essentially what I described above – options, forwards, swaps, and CFDs (Contract for Differences). Each works differently, but they all share one similarity: they let traders gain exposure to price movements without necessarily owning the asset.
- A forward contract is traded in the over-the-counter (OTC) market and is effectively a private, customisable transaction between a buyer and a seller to purchase and sell the underlier at an agreed price and date in the future. Counterparty risk is quite high here, as there is no exchange guaranteeing the trade.
- A futures contract is often referred to as an ‘exchange-traded forward', which ‘obligates’ both parties to transact at a specified price on a fixed date. However, the fact that futures contracts trade on an exchange guarantees that both parties will fulfil their obligations.
- An options contract grants the buyer the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price at or before a specified future date. For the buyer to secure this ‘right’ the holder must pay a premium to the seller – or ‘writer’.
- A swap is an agreement to exchange future cash flows, with the norm being that one side pays a cash flow based on a variable rate, while the other pays a cash flow based on a fixed rate. Importantly, swaps are predominantly traded in the OTC market.
- CFDs are contracts that pay out the difference between the opening and closing price of an asset, popular for their simplicity and accessibility with retail brokers.
What are the benefits of using derivatives over buying assets?
Hedging capabilities:
It may surprise you that derivatives were not originally created for speculative purposes; they were primarily designed for hedging. For those new to the financial markets, hedging is a common risk-management approach used by market participants to offset potential losses in an investment by taking an opposite position in an identical or highly correlated asset.
I think it is very important to remember that hedgers ‘transfer’ risk to manage uncertainty, while speculators ‘assume’ risk, taking a view on whether the underlying asset will increase or decrease in price.
A common way to describe a basic hedging strategy is through an example. Suppose a large bakery plans to buy 50,000 bushels of wheat in 3 months. As you can imagine, a lot can happen in that time in terms of its price. So, the company wants to lock in the price now and create a price guarantee. The company goes ahead and executes 10 wheat futures contracts, with a delivery price of US$5 per bushel; each contract guarantees delivery of 5,000 bushels in 3 months.
The bakery has now locked in a price for wheat, expecting to pay a total of US$250,000 in 3 months. Let’s say that the price of wheat rises (drops) to US$6 (US$4), meaning the total value of the company’s futures position has risen (dropped) to US$300,000 (US$200,000).
The bakery would then purchase its wheat from its usual supplier. In the case where the price has risen, the bakery made US$50,000 on its futures contract and paid US$300,000 to its suppliers, effectively using the futures contracts to offset the price rise and pay the fixed price of US$250,000. The US$50,000 gain on the futures position cancels out the US$50,000 the bakery overpaid its supplier compared to the original US$5 price – netting back to the locked-in US$250,000 regardless of what the market did.
In the event of a price drop, the bakery must buy its wheat at the lower market price of US$4 from its supplier, paying only US$200,000, but takes a US$50,000 loss on its futures position. That loss offsets the savings from buying more cheaply, so the bakery again ends up paying a net of US$250,000. That is the cost of protection, I am afraid.
This is the essence of hedging: the bakery gave up the chance to benefit from a price drop, in exchange for certainty about what it would pay.
Leverage – the double-edged sword:
One of the biggest benefits traders gain from using derivatives is the leverage offered. Leverage essentially allows traders to stretch their capital. I know there are differing opinions regarding the subject, but if what you are investing in provides a return, then leverage has helped you gain more with less; but if the investment delivers poor results, it can be a disaster if not properly managed.
It is very important to understand that leverage and margin are closely related concepts. In fact, one cannot work without the other. To illustrate this, let's look at a simple comparison of CFDs in the Forex market. Imagine an investor in the US wants exposure to €100,000.
With EUR/USD trading at US$1.2000, getting your hands on €100,000 outright would mean paying US$120,000. But when trading on margin with 100:1 leverage and a 1% margin requirement, the same exposure requires only US$1,200 in initial margin. Price movements and pip value in this leveraged position mirror those of the unleveraged trade exactly, so if EUR/USD rises to US$1.2200, the trader realises the same profit. For a more detailed breakdown, consider checking out this post in the FP Markets Trading Academy.
But leverage cuts both ways. A move against the position hurts just as much as a move in its favour helps — and because the margin is so small, it doesn't take much of a price swing to wipe it out. Go far enough, and the broker can request additional funds or close the trade automatically – technically known as a ‘margin call’. Leverage also does not make a trade more likely to win; it just makes the result, good or bad, much bigger.
Ability to sell short stocks:
If you are interested in trading shares, selling (commonly referred to as ‘shorting’) a stock can be tricky, often involving borrowing the shares from the broker – for a cost – selling them and buying them back later, hopefully at a lower price.
Using derivatives to short stocks – or any asset for that matter – certainly offers a more streamlined approach. With CFDs, for example, selling stocks is just as straightforward as buying them (entering ‘long’). In the options market, a trader can also buy what is referred to as a ‘put option’. This essentially allows a trader to open a short position in a market for a relatively small premium (paid to the writer), which is the maximum loss. Shorting with a futures contract is similar. The only difference between these and options is that with futures you are committed to trading, whereas with options you have the right not to execute the position.
The bottom line
Derivatives offer traders a number of benefits over purchasing physical assets, including the ability to hedge risk exposure, apply leverage to speculative positions, and, of course, simply short-sell markets.
However, one key thing to remember is that derivatives do not replace the underlying asset; they replace the need to own it. Whether it is a bakery locking in a price guarantee or a day trader using CFDs to short stocks without needing to borrow shares, the flexibility of the derivatives market is a major draw.
Written by FP Markets Chief Market Analyst, Aaron Hill
Frequently asked questions (FAQs)
Derivatives represent contracts that, for the most part, obligate a buyer and a seller to buy and sell an underlying asset at a fixed price at a future date.
Hedging essentially transfers risk, usually to create a price guarantee, while speculating involves assuming risk by taking a view about whether the underlying asset will gain or lose value.
While there are several positive aspects of derivatives, the major benefits for many traders are the ability to hedge positions, use leverage, and short sell stocks.
