If considering investment strategies which go beyond the basics of investing in stocks and shares, commodities or bonds then one option is to consider derivatives trading in the form of futures and options.
Derivatives Trading: What are Derivatives?
Derivatives are a trading instrument which is used to gain an exposure to an investment or speculation on an underlying asset or security, without having to actually buy or invest in the asset. As such, the value of the transaction is derived from the asset, hence the name derivative.
There are a wide range of derivatives available which range from simple exchange traded derivatives such as futures and options, such derivatives are sometimes referred to as vanilla derivatives. More complex derivatives are then referred to as exotics and may include over the counter (OTC) derivatives, as well as exchange traded derivatives.
Futures Trading: What are Futures?
Futures represent a contract to buy a commodity, asset or security at a fixed price at some point in the future which is stipulated by the contract end date. A profit or loss will then be made, dependent upon the movement in the price of the item from which the value of the futures contract is derived.
For example, a futures contract for gold is purchased today with a promise to buy 1,000 contracts at £1 each or £1,000 in three months time. If over the three months the market value of the contracts appreciates to £2 each, then on the day of settlement the futures trader will be able to buy the contracts for £1,000 and make a profit by selling at the market rate of £2, making a profit of £1,000. However if the market value of the contracts had have depreciated, then the reverse scenario would have seen experienced and a loss incurred.
Options Trading: What are Options?
Options are in many ways a similar derivative to a futures contract however, the key difference is that in options trading the trader has the right but not the obligation to purchase the contract on the settlement date.
For the privilege of the option, an options trader will pay a premium to the writer of the options. Where the value of the underlying asset moves in a way which is favourable to the trader, then the trader will exercise the right to buy the option and thus crystallise the profit in the same way as with a futures trade.
However, where the price of the underlying asset moves in a way which would see a loss for the trader, the trader will simply fail to exercise the right to buy the option and loss will be limited to the premium paid.
In summary, derivatives are instruments which derive their value from an investment in another asset, commodity or security, as opposed to being a direct investment. Two of the most common derivatives are futures and options, both of which see traders able to make a profit or loss based upon fluctuations in price between the date of issue and a future settlement date.
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Frank Smith - Frank Smith currently works as an full time industry analyst for a well known construction company in Lincolnshire. In his spare time, ...
