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Derivatives are a form of financial security. A derivative will have a value that is derived from either an underlying asset or a group of assets. As such, a derivative is a contract between two parties based upon the price of the asset and its performance in underlying markets. These assets often include stocks, commodities, currencies and numerous other markets.
Derivatives are a complicated but increasingly popular form of trading. They allow investors a powerful way to participate in the price actions of underlying securities, with investors seeking to transfer certain risks associated with the underlying security to another party.
Two of the most popular forms of derivatives contracts are options and contracts for difference. Here, we’ll take a look at both.
Options
There’s a popular saying among trading that “options give you options”. This is because, if you buy an options contract, it provides you with the right to buy or sell an underlying asset at a set price before a certain date. However, this is a right, not an obligation, giving investors more choice.
A ‘call option’ gives the holder the right to buy, while a ‘put option’ gives the holder the right to sell.
Options allow investors to either hedge against risk or take additional risk speculating. They are traded on exchanges and are centrally cleared, providing both liquidity and transparency. Factors that determine the value of an option include:
- Time premium that decays as the option approaches expiration
- Intrinsic value that varies with the price of the underlying security
- Volatility of the stock or contract
Contracts for Difference
Contracts for difference are also known as CFDs. CFD trading is one of the simplest and easiest ways to trade most of the global financial instruments.
Essentially, a CFD is a derivative product that tracks the price movement of an underlying asset, such as a commodity or a stock market index. They are a flexible form of trading, as they allow you to participate in either rising or falling markets, as well as allowing investors to get exposure to the price movement of an instrument without having to buy the underlying product.
Contracts for difference are unavailable in the USA, but they are still widely available in countries such as the UK, France, Singapore and Japan.
Options and contracts for difference are both incredibly popular ways of trading derivatives contracts. It’s worth investigating how they may help with your portfolio.
This article does not necessarily reflect the opinions of the editors or management of EconoTimes
