What is a Derivative

What is a Derivative

What is a Derivative: Types, Applications, and Future Prospects
Financial derivatives are a powerful tool primarily used by investors for risk management, hedging against adverse market changes, and speculating on future price changes of underlying assets. Derivatives have become an integral part of the global financial system, and their usage has been rapidly growing in recent years. In this article, we will discuss what derivatives are, the different types of derivatives and their applications in the U.S. stock market, as well as their prospects in 2023 and their impact on the Ukrainian market.

What is a Derivative?

A derivative is a financial instrument whose value depends on an underlying asset, such as a stock, bond, commodity, or currency. The value of the derivative is influenced by changes in the price of the underlying asset, and derivatives can be traded over-the-counter or on exchanges. (In English, the word derive means to originate from, meaning when talking about derivatives, we always understand that there is a base and something derived from it.)

To simplify the concept of a derivative and illustrate how it works practically, a derivative is a contract between two parties, where one party agrees to buy or sell the underlying asset at a future date for a pre-determined price.

So, what types of derivatives exist?

There are several types of derivatives, such as options, futures, swaps, and forwards.

Options: An option is a financial contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a pre-determined price by a specific date.
For example, stock options are not actual stocks—they are the right to buy a certain number of company shares at a fixed price, which is usually called the exercise price or strike price. However, you are never obligated to exercise the options, which is why they are called options. Many startups, private companies, and corporations include them in their incentive plans for potential employees. Companies often offer stock options as part of compensation so that employees can share in the company's success. Options can be used for hedging, speculation, or income generation.

Futures: A futures contract is an agreement between two parties to buy or sell the underlying asset at a pre-determined price and on a set future date. Futures are standardized contracts traded on futures exchanges and are used for hedging or speculation.

Swaps: A swap is an agreement between two parties to exchange cash flows based on a notional amount. The most common type of swap is an interest rate swap, where the two parties exchange payments based on a fixed and floating interest rate. For example, a currency swap agreement can ensure a certain exchange rate for two currencies over a specified period.

Forwards: A forward contract is an agreement between two parties to buy or sell the underlying asset at a future date for a pre-determined price. Forwards are similar to futures but are traded over-the-counter and are not standardized.

Derivatives for the U.S. Stock Market:

Derivatives play a vital role in the U.S. stock market, as traders and investors use them for risk management, speculation on price changes, and income generation. The most common types of derivatives used in practice in the U.S. stock market, and which are highly popular among retail traders, are options and futures.

Futures are used by investors to hedge potential losses or to speculate on price changes. Futures contracts are traded on futures exchanges such as the Chicago Mercantile Exchange (CME) in the U.S., the Intercontinental Exchange (ICE) in the U.K., and the Shanghai Futures Exchange (SHFE) in China. The value of futures is based on the price of the underlying asset, and settlements of futures contracts can be made in cash or through the delivery of the underlying asset.

Futures contracts require the buyer or seller to buy or sell the underlying asset at a specific price in the future. In contrast, options give the holder the right, but not the obligation, to buy or sell the underlying asset at a pre-determined price on or before a certain date.

Options can be traded on stock exchanges, such as the New York Stock Exchange (NYSE) in the U.S., the London Stock Exchange (LSE) in the U.K., and the Tokyo Stock Exchange (TSE) in Japan. Specialized exchanges such as the Chicago Board Options Exchange (CBOE) and CME Group in the U.S., which are dedicated exclusively to options trading, can also be used.

Additionally, online brokerage platforms are available for retail investors.

The main difference between futures and options is that futures require the contract holder to buy or sell the underlying asset, whereas options provide the right, but not the obligation, to do so. Furthermore, futures contracts have standardized terms and are traded on exchanges, while options can be customized and traded over-the-counter (OTC), not just on exchanges. Additionally, options on futures can be traded, which offers significant advantages to "niche traders" for a number of reasons:

• Creation of unique trading strategies combining options on futures and futures on the underlying asset;
• Reduction of risk in positions;
• More accessible margin requirements compared to futures.

Is it possible to profit from Derivatives in Ukraine?

The use of derivatives in Ukraine is still in its early stages, and the derivatives market is relatively small and underdeveloped. However, there is significant potential for the growth of the Ukrainian derivatives market as the country’s economy continues to grow and attract foreign investments.

Can you trade Derivatives through Fondexx?

Yes, Fondexx offers the opportunity to trade Options using the Sterling Trader Pro or Takion platforms. If you are interested in trading derivatives on the American Stock Market, register with us through the link, and our manager will definitely advise you on all the advantages of trading with us.

Why doesn’t Fondexx offer Futures trading?

Throughout Fondexx’s operation and based on the personal experience of the company’s founders, we have arrived at a trading model that includes common stocks and options for hedging, with all other strategies being traded using ETF stocks.

Where can I see what the derivatives trading process looks like?

Derivatives trading is thoroughly discussed in our exclusive course by Dmitry Bakhtin, NYSE PRO. However, if you would like to momentarily experience being an options trader, we recommend watching how the trading process looks visually via the link to Dmitry’s YouTube channel.

Conclusion

In summary, financial derivatives are important tools for risk management and income generation, but they can also be complex and risky. Before investing in derivatives as an investor, you should understand the different types of derivatives and their application in the global financial system. Options, futures, swaps, and forwards are the most common types of derivatives used by investors to manage risks, hedge against unfavorable market changes, and speculate on future price changes of underlying assets.

The U.S. stock market is the most significant derivatives market, and options and futures are the most commonly used derivatives on this market.

If you wish to profit from derivatives as an investor, it is important to understand the risks associated with derivatives and seek professional advice before investing in them. However, if you are interested in speculative opportunities in this asset class, we would be happy to welcome you to our educational courses or to trade under our best conditions for professional traders in the U.S. stock market.