Options, Futures, Forwards & CFDs: How Major Derivatives Work

Derivatives

While financial derivatives began to take off as financial instruments back in the 1970s, the first financial derivative dates back to Ancient Greece in 60 BCE. Thanks to newer valuation techniques, the derivatives market has since taken off in the major financial market, including the UK. Since then, sophisticated investors have used derivatives to hedge against risks, gain access to markets or assets, or for speculating against price movements or major financial assets.

 

Post-Brexit Derivatives

Before discussing derivatives, it is important to note that a part of the activity noticed in capital markets moved to the EU from the UK. Even so, the UK is still the largest hub in Europe for capital markets. Banks introduced changes in their operating models because of regulations while not taking into account commercial considerations. Why is this relevant?

UK businesses involved in the financial market that deal with derivatives of all kinds now have to deal with increased costs across the European operations of banks. And the EU tries to reduce UK CCPs exposure.

There are different rules in the UK and the EU when it comes to trading derivatives. What has to be highlighted is that the UK firms involved in the industry fall under UK derivatives trading obligation (UK DTO). The businesses have to trade some liquid derivatives with the use of UK trading venues. If the firm is trading with an EU firm that uses EU DTO, the restriction does not apply.

To sum up, companies in the UK can still use derivatives and even trade them, which was what was questioned after Brexit. However, this is only possible through an UK authority or when dealing with a firm that is governed by EU trading laws.

 

What Are Derivatives?

Financial derivatives are financial instruments or contracts between two parties linked to a particular financial asset or assets. As the name suggests, they derive their value from that underlying asset/s. These underlying assets range from currencies and interest rates to bonds, stocks and commodities like oil, gold, natural gas and wheat.

There are several derivatives investors and traders can use for various reasons, as mentioned above. But that’s not to mean derivatives don’t pose a risk. They are highly volatile, have complicated valuation methods and due to their highly speculative nature, often pose a huge loss to traders.

Let’s talk about the most common derivatives and how they work.

 

Options

These are agreements between two traders to sell or buy an underlying asset at a preset date and price. However, options give the buyer the choice or option to exercise the contract upon expiry. That means upon expiry; the buyer can choose to go ahead with the contract or not.

When exercising the right to buy or with an option, the timing will depend on the style of the option itself. European options allow the parties to only exercise the option at the set date of expiry, while with American options, the parties can execute the contract at any time before the expiration date.

 

Futures Contracts

Futures contracts are an agreement between the buyer and the seller to purchase and deliver the underlying asset/s at an agreed future date and price.

Unlike options where traders are not under any obligation to exercise the contract, in futures, the involved parties are under the obligation to fulfill the contract by buying or selling the underlying asset.

These contracts are standardized and traded on exchanges. They are quite common among traders speculating on future prices or looking to hedge against certain risks, like interests and currencies.

Nevertheless, not all futures contracts are settled at maturity, especially when the parties are speculating on price movements. On such occasions, both parties end the contract before the expiry day by offsetting it with a new contract. This is referred to as cash settlement as the gains/losses for either party from the cancellation of the contract are more of an accounting cash flow issue.

 

Forward Contracts

These are more like futures. Unlike futures, forward contracts or simply forwards do not trade on exchange platforms but over the counter. Because of this, they have an edge over futures as they allow both parties to customize the terms of the contract, including the size, settlement process and period. That’s not to say they do not pose a risk for traders.

For starters, they have a greater credit risk, which means either of the parties may not honour the contract. Second, where parties decide to offset their positions with another counterparty, it introduces counterparty risk due to the introduction of other traders in the contract.

 

Contracts For Difference (CFDs)

Contracts For Difference allow traders to exchange an underlying asset’s price difference from when they open the trade to when they close it. As a trader, you can buy a CFD to speculate on the price of an asset, like gold, moving either up or down. How much you make or lose from this contract will depend solely on the price movement of the gold.

While trading of CFDs is illegal in the US, it has become quite a big part of the derivatives market in the UK and still growing.

 

Trading Derivatives With PrimeXBT

With so many derivatives to trade, the choice of what to settle for will depend on your individual needs. However, PrimeXBT, an award-winning multi-currency trading platform provides traders access to the derivatives markets with its online platform and mobile app.

Akeela Zahair
FULL_SITE_ACCESS
PROFILE

Posts Carousel