Greetings Traders, and welcome back. Chris here,
bringing you some more information to add to your growing
library of trading knowledge.
Today, we're gonna be discussing the topic of what derivatives
are as they pertain to us in the trading world.
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keep coming out with informative content for you all out there.
But without any further ado, let's dive on into derivatives
and learn everything that we need to know about them.
The term derivative relates to something which has a value
deriving from an underlying variable asset.
Financial derivatives can be used in hedge scenarios or as
a means of taking a speculative position on a particular asset.
Due to the structure of financial derivatives, a relatively
small movement in the underlying assets' value can significantly
impact the value of the derivative.
This is due to what we call the leveraged effect.
When people ask, "what are derivatives?", they are often surprised
to learn that their use mainly relates to risk hedging.
Many people automatically assume that derivatives are more
closely associated with speculative investors than those
that are looking to protect or cover existing positions.
Even those buying derivatives without any asset to cover
can create strategies that limit the downside but maximize the upside.
They should not be seen as just an all-out gamble.
It is also a commonplace for investors to use derivatives
to protect and maintain the value of an existing portfolio.
Then there's the commercial element
for those that are looking to acquire or sell commodities
as part of their business operations.
The opportunity to secure supply well before the delivery date
is essential when planning at a predetermined price.
There are two main ways to acquire derivatives.
The first that we'll discuss is the derivative exchanges.
Derivatives traded on open exchanges are marked to market
each day, prompting adjustments in margin calls and collateral,
reducing the risk of default.
This reduced risk of default can create colossal interest,
which is reflected in their deep seated liquidity, which
is a must-have for large scale investors.
Exchanges with high levels of liquidity create an environment
for highly efficient pricing to help avoid pricing anomalies
as well as arbitrage positions.
It is also important to note that you can buy and sell
exchange-traded derivatives as often as you want before expiry.
All trades are carried out through a clearing house, which
ensures efficient and prompt settlement.
The second way we can acquire derivatives is referred to
as over-the-counter derivatives, also known as "OTC" derivatives.
These are transactions negotiated and completed away from a recognized market.
This is something where the two parties can directly negotiate
the arrangements' price, volume, and duration with their
OTC derivatives. This greater flexibility is appreciated more
in the commercial world, but it comes at a cost.
Typically, you cannot trade OTC derivatives with other parties
after the initial setup. Even in the cases where it is possible,
it can sometimes be challenging to achieve for a fair price.
While derivative exchanges will adjust margin calls and cover
daily, OTC derivatives tend to be cash on delivery.
Consequently, we may not become aware of any issues with
the other party until the arrangement needs to be settled.
In reality, there are enormous financial and commercial institutions
involved in the OTC derivatives market.
Therefore, it is possible to reduce the chances of default
by trading via recognized firms with a strong reputation.
When understanding derivatives, it can be helpful to look
at them as two different levels.
Firstly, we have the type of derivatives, and then we have
the assets on which these derivatives are based.
The most common types of derivatives are here on the left
in this section. We have forwards, futures, options,
and swaps. These represent the different types of derivatives
and the most common types of underlying assets
then fall into this category where we have have commodities,
stocks, bonds, interest rates, and currencies.
While you can trade derivatives on an array of different
assets, each derivative will have many common factors, which
include things like asset, price, quantity, delivery, date, and margin.
These are some common similarities across the board.
Some derivatives are traded in isolation and others is bundles,
but the core information is still the same.
When you purchase or sell a derivative,
unless the position is closed before expiring, you are generally
committing to either purchasing or delivering an asset.
When writing a derivative, which is known as going short,
you will only be expected to provide collateral to cover
an element of the full financial exposure.
This is referred to as margin.
Consequently, it is possible to create significant leverage
on relatively small investments.
The result is an environment in which you may incur
substantial losses or make substantial gains.
Be careful when shorting derivatives.
Whether we're looking at oil futures, stock futures, or the
E-mini S&P 500 futures, the concept is going to be the same.
A buyer is obligated to buy an underlying asset at a predetermined
price and date in the future. A seller is obliged to go ahead and deliver
an underlying asset at a predetermined price and date
in the future. Many people confuse futures contracts and
forward contracts because they are pretty similar
on the surface. The main difference is the way they are traded
and that futures contracts are standardized for quantity.
Futures contracts are marked to market like we mentioned
previously, and this means that margin requirements are continuously
adjusted. The required margin call can increase or decrease
across the duration of a futures contract.
As futures margin calls are closely monitored,
this significantly reduces the risk of default.
As a result, this facilitates the often heavy trading of
some futures contracts, like indices, currencies, and commodities.
This graph shows the top 10 liquid futures contracts that are traded worldwide.
On the left hand side, we have something that we all know
and love the S&P 500 E-mini. Then we have the 10 year
T-note and we keep working our way down the spectrum.
This should give you an idea of how powerful and how much
people actually trade the S&P 500 E -mini when you look at it
in comparison with the top 10 most commonly traded by volume
liquid futures options, there are. It is an impressive statistic, to say the least.
As we mentioned, it is very common for new traders to confuse
futures contracts with forward contracts
when discussing terminology.
Some of the characteristics of forward contracts are
the fact that there's no central market.
A forward contract is an agreement between two parties, customized
to consider a commodity, amount, price, and delivery date.
We can see forward contracts as over-the-counter instruments,
those OTC things that we mentioned, with no centralized clearing house,
which is always something we see with futures contracts.
With forward contracts, there's no margin adjustments.
Regulated futures markets operate on the clearing house principle,
effectively taking the collective risk of default.
Forward contracts are unregulated and therefore the terms
and conditions are stipulated by the two parties.
As there is no central clearinghouse with forward contracts,
the risk of default is much more significant.
While futures contracts margins are adjusted daily,
with forward contracts, there is no such adjustment.
Settlement is simply on the agreed upon delivery date.
With forward contracts, there is a high degree of flexibility.
While the risk of default is higher, the flexibility is
arguably what is off-weighing that risk.
The final two most common ways to trade derivatives come
in the form of both options and swaps.
With options, we have a list of variables that are always going to be present.
We have an underlying asset, we have a strike price,
an option price, a quantity, and an expiration date.
All of these things are going to be listed in the options contract,
and with options, we have call options, which is
when we're buying, and we have put options, which is when
we are selling or expecting something to be going down.
Then on the right hand side of the screen, we have information regarding our swaps.
Many traders have heard of swaps, but don't know a whole lot about them.
There are several variables that are going to be constant
in the world of swaps, such as the asset, the amount,
the duration, the base price, and the premium.
These are all things that we can expect to see in a swap scenario.
Unlike futures contracts, where there are clearly defined
contract sizes, an interest rate swap would be customized
to accommodate both parties. As the principle involved does
not change hands, just the cash flow/liability,
the financial risk is then reduced.
While there is always an element of default risk with any
investment transaction, the swap market is dominated
by businesses and large financial institutions.
As a always, the risk of default is reflected in the quality
of the parties that you're looking to transact with.
If swaps is something of interest to you, by all means, continue
down the educational rabbit hole,
but know that swaps are not a statistical majority of the
choices of retail traders.
Whether you're looking to protect an existing position
or facilitate a speculative investment, derivatives can be your go-to.
We covered the four main ways that you can go about accessing
and utilizing derivatives. Some options will be more regulated, while other options
will be less regulated. Some options will have more liquidity.
Other options will have less liquidity.
Some might be more suitable for the bigger investors.
Others might be more suitable for the retail investors and the smaller investors.
It's ultimately going to be up to you which ones you want
to investigate further, but I strongly recommend keeping
that educational library growing. Until next time,
thank you for joining me, as always folks. I will see you soon.
Best of luck in the markets out there everybody. Over and out.