How to trade in derivatives
Before knowing how to trade in derivatives, it is important to know some common terms. The first term to be explained is a forward contract. In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.Forward contracting is very valuable in hedging and speculation. The classic hedging application would be that of a wheat farmer forward -selling his harvest at a known price in order to eliminate price risk. Alternatively, a bread factory may want to buy bread in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts change in prices, then they can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction making a profit.
The types of derivatives investment methods include:
- Forward Contracts :
A forward contract is an agreement between two parties (a buyer and a seller) to buy or sell a stock at a future date, but agree on a price in present day. This type of contract is common in businesses and usually does not have the option of cancellation.
- Future Contracts:
A future contract is also an agreement between a buyer and seller to buy or sell something in a future date which was agreed upon . The difference is, the trades held during this contract is subject to a daily evaluation and settlement. Future contracts were branched out from forward contracts and unlike forward contracts, they trade on organised exchanges which are known as “future markets”.During the daily settlement, investors who have suffered losses would normally be covered by investors who have gained profits to maintain the balance.
- Options Contracts:
Option contracts have two further types, call options and put options (also known as calls and puts for short) . Calls give the buyer the right but not the obligation to buy a portion of the underlying asset at a fixed price or before a date in the future . Puts is the same, except the buyer has the right to sell.
- Swaps :
Swaps are an agreement between two parties to exchange cash flows, using a prearranged formula in the future . They are also a subsidiary of forward contracts. There are two types of swaps, interest rate swaps and currency swaps.
Another example which expands on derivative trading and future contracts are businesses which have their headquarters in one country and expand their branches overseas. Consider a CEO of company ABC, who is primarily located in the UK and is expanding business over in the US. The revenue is being generated in GBP and the employees overseas in the US have to be paid in USD . Typically, £1 is about $1.5. Multiplying this by 1000s when computing salaries, makes a large difference. If £1 is shifted even marginally to $1.6 in USD, there are large differences of over $400, depending on the salary of the employee. Suppose the British CEO consults with an American CEO who faces the opposite problem, they can enter a future contract and trade revenues to resolve this problem. This type of contract is known as “Swaps” and is typically used in markets such as investment banking or multinational corporations where currencies fluctuate constantly and rates are never stable.