What is Derivative Trading?

In short Derivative trading is when traders speculate on the future price of an asset by the buying or selling of derivative contracts with the aim of achieving enhanced gains when compared with buying the underlying asset outright. Derivative trading has grown in popularity since the 1980s, and investors can now trade derivatives on a range of financial markets including stocks, currencies, and commodities.

Traders can also use derivatives for hedging purposes in order to mitigate their risk against an existing position. With derivatives, traders are able to go short and profit from falling asset prices. Therefore, they can use derivatives to hedge against any existing long positions. This is useful for physical commodity exporters who need to mitigate their risks in order to avoid potential financial loses should the global markets of that commodity go negative as the commodity is enroute.

Leverage with Derivatives
Risk Management

Leverage with derivative trading

Trading with leverage on derivatives involves entering into a buy or sell position and speculating on which way their chosen market will move, using a reasonably small margin/deposit. Without the investor actually owning the underlying asset, their profits or losses will correlate with the performance of the market. However, leverage will cause these profits/losses to be magnified when compared with buying the underlying asset outright.

Risk management

To mitigate the risks in trading leveraged derivatives, it is important to plan a trading strategy in advance. A popular risk-management tool traders can use when trading with leverage is a stop-loss. By implementing a stop-loss order to a position, a trader can limit losses if the chosen market shifts in an unfavorable direction. However, it is important to be aware of potential risks, such as the market experiencing a negative short-term fluctuation, which could activate the stop loss order before the market conditions improve again.

Leverage with Derivatives: Leverage with derivative trading

Trading with leverage on derivatives involves entering into a buy or sell position and speculating on which way their chosen market will move, using a reasonably small margin/deposit. Without the investor actually owning the underlying asset, their profits or losses will correlate with the performance of the market. However, leverage will cause these profits/losses to be magnified when compared with buying the underlying asset outright.
Risk Management: Risk management

To mitigate the risks in trading leveraged derivatives, it is important to plan a trading strategy in advance. A popular risk-management tool traders can use when trading with leverage is a stop-loss. By implementing a stop-loss order to a position, a trader can limit losses if the chosen market shifts in an unfavorable direction. However, it is important to be aware of potential risks, such as the market experiencing a negative short-term fluctuation, which could activate the stop loss order before the market conditions improve again.

Types of Derivatives

There are several types of derivative products that a trader can trade, with each of them having significant differences in their details, risks and benefits. Spread betting, CFDs, forwards, futures and options are some of the most popular types of derivatives among traders. Such strategies may be able to be used on HootDex for certain synthetic digital assets.

CFD Trading
Forward Trading

CFD trading

CFD trading stands for “contracts for difference”, it is is another leveraged derivative product that enables traders to speculate on short-term price movements. It is a contract between two parties on a peer to peer basis to exchange the difference between the opening and closing prices of a specified financial instrument at the end of the contract.

Similar to spread betting, you do not actually own the underlying asset. Instead, you buy or sell a number of contracts for a particular asset depending on whether you think the movement of price will rise or fall. You gain multiples of the number of CFD contracts you have bought or sold for every point the price of the instrument moves in your favor. In the opposite scenario, when the price moves against you, you will register a loss.

There are a number of benefits of trading CFDs, such as the ability to trade on the price of a product that is falling as well as rising. Therefore, you can aim to benefit from going short and selling as well as buying opportunities, which is also true for spread betting. Through periods of short-term volatility, many investors trade CFDs as a way of hedging their existing portfolios.

There are a number of risks of trading CFDs as well, which traders need to be aware of and it is advised to be aware. Gapping is one example, this occurs when the price of an asset suddenly moves from one level to another, without passing through the level in between. Traders may not always have the opportunity to place a market order between the price levels. Gapping arises as a result of market volatility. It is possible to limit the risk and impact of market volatility by applying a guaranteed stop-loss order. Another important aspect to be clear on are the costs associated with trading CFDs, they are holding costs. These are charged to a traders account if they hold such positions on certain securities overnight.

Forward trading

Forward trading is a transaction between a buyer and seller to trade an asset at a future date and at a specified price, this can be a digital or physical asset. The forward contract’s value is based on the stability of the underlying asset and it includes the agreement of the asset price via a smart contract and trade date. Forward trading is an alternative to purchasing an asset at spot price.

An advantage of forward contracts is that the agreement to buy and sell at a specific price in the future ensures that a buyer of a Forward Contract is protected from unfavorable market movements, so if the market should rise dramatically they would have a locked in price. A seller would have the opposite effect.

On the flip side, it can work against a buyer should the underlying value of an asset should drop, they are locked into a specific price and cannot take advantage of better pricing. For a seller this is the opposite as it would have the opposite effect.

CFD Trading: CFD trading

CFD trading stands for “contracts for difference”, it is is another leveraged derivative product that enables traders to speculate on short-term price movements. It is a contract between two parties on a peer to peer basis to exchange the difference between the opening and closing prices of a specified financial instrument at the end of the contract.

Similar to spread betting, you do not actually own the underlying asset. Instead, you buy or sell a number of contracts for a particular asset depending on whether you think the movement of price will rise or fall. You gain multiples of the number of CFD contracts you have bought or sold for every point the price of the instrument moves in your favor. In the opposite scenario, when the price moves against you, you will register a loss.

There are a number of benefits of trading CFDs, such as the ability to trade on the price of a product that is falling as well as rising. Therefore, you can aim to benefit from going short and selling as well as buying opportunities, which is also true for spread betting. Through periods of short-term volatility, many investors trade CFDs as a way of hedging their existing portfolios.

There are a number of risks of trading CFDs as well, which traders need to be aware of and it is advised to be aware. Gapping is one example, this occurs when the price of an asset suddenly moves from one level to another, without passing through the level in between. Traders may not always have the opportunity to place a market order between the price levels. Gapping arises as a result of market volatility. It is possible to limit the risk and impact of market volatility by applying a guaranteed stop-loss order. Another important aspect to be clear on are the costs associated with trading CFDs, they are holding costs. These are charged to a traders account if they hold such positions on certain securities overnight.
Forward Trading: Forward trading

Forward trading is a transaction between a buyer and seller to trade an asset at a future date and at a specified price, this can be a digital or physical asset. The forward contract’s value is based on the stability of the underlying asset and it includes the agreement of the asset price via a smart contract and trade date. Forward trading is an alternative to purchasing an asset at spot price.

An advantage of forward contracts is that the agreement to buy and sell at a specific price in the future ensures that a buyer of a Forward Contract is protected from unfavorable market movements, so if the market should rise dramatically they would have a locked in price. A seller would have the opposite effect.

On the flip side, it can work against a buyer should the underlying value of an asset should drop, they are locked into a specific price and cannot take advantage of better pricing. For a seller this is the opposite as it would have the opposite effect.

Options and futures

Typically an option is an agreement between two parties that gives the buyer the right, but not the obligation, to purchase or sell an asset at a set price on or prior to a specific date. Options can be traded on several types of underlying securities such as stocks, ETFs, and indices. Forex options work in the same way but are specific to currency pairs and are driven by factors such as interest rates, inflation expectations, and geopolitics. In the realm of synthetic derivative assets, the parties do not take possession of an asset in contrast they are solely wagering on the underlying assets price, up or down.

Typically futures trading is the trading of financial instruments as contracts, it is an agreement between parties that an asset will be exchanged at a predetermined price and date in the future. One party is obligated to purchase the asset once the futures contract expires whilst, when expired, the other party is obliged to produce the asset. In the decentralized space two parties on a peer to peer basis can opt to engage in such an agreement using smart contracts as it relates to digital assets such as cryptocurrency, non-fungible tokens or the digital version of a physical commodity.