Derivatives Trading Explained
A derivative is simply an asset that derives its price from another underlying asset. When you are trading derivatives, you are actually trading a product that is a bet on the value of the other product it is designed to track.
Derivatives are widely used in the creation and management of Exchange Traded Funds (ETFs). When you purchase shares in a popular ETF like the SPY, you are actually purchasing derivatives that will perform nearly identical to the actual S&P 500 stock index. This makes running a fund, or index investing much more simple than having to buy all the stocks to mirror the index yourself. Imagine having to buy 500 stocks in your Robinhood account? That would be very time-consuming, and costly in trading commission. Read more on investing an entire sector using ETFs here.
Now that you understand the general premise of a derivative in financial markets, let’s take it a step further and discuss the type of derivatives there are.
Popular Derivative Trading Assets
There are three main derivative trading instruments that are widely used in the industry. Derivatives can be used for speculation in day trading or even portfolio hedging by institutional money managers.
1. Futures
Derivative products that trade stock market indices, commodities, and currencies as their underlying asset. One of the most popular futures products is the ES contract, which tracks the S&P 500 underlying index. Learn how to become a futures trader step by step.
2. Options
Options are derivative prices and can be traded on single stocks or indices. Retail traders have made stock options extremely popular because of their cheap purchase price and big profit potential. Read more about options basics here.
3. CFDs
Contracts for Difference (CFDs) are less structured and do not trade on a transparent marketplace. These contracts can have more favorable taxation in European countries. You can trade CFDs on commodities, and they are extremely popular in currency trading. Most FX brokers are actually offering you a CFD product. While other derivatives are traded on a public exchange, these contracts are traded in over-the-counter form in private marketplaces.
There is also a product called a “forward contract”, but it is not often used by retail traders and is mostly designed as a hedging mechanism.
Benefits of Derivatives Trading
There are many benefits of derivatives trading, and it is one of the reasons we mostly trade them in our trading rooms. Let’s take a moment and review some of the top benefits.
1. Lower Capital Required – Leverage
One of the biggest benefits of day trading derivatives is that they provide a great deal of leverage. That is, you can start trading these products with a fairly small trading account. While this is a big benefit, it can also be very risky for inexperienced traders. This is especially true at the very beginning of the journey.
2. Pattern Day Trader Rule (US)
Regulators in the US have something called the Pattern Day Trader rule, PDT for short. This regulation requires you to have over $25,000 USD in your account if you are going to day trade actively. Learn more about the pattern day trader rule here. However, with a futures trading account, you can start with an account as small as $50, and bypass the PDT rule. Also, if you are using a cash account you can do the same with options trading.
3. Hard to Access Markets
With derivatives, you can get access to the price appreciation of assets that are hard to actually own. Take for example gold, it takes a lot of effort to accumulate a physical position, and that comes at an administrative cost of over 10% extra on top. Oil is another example, where it is hard to purchase and store a barrel of oil. You can get easy exposure to these assets through the use of derivatives, without ever having to physically own the underlying asset.
4. Around the Clock Trading
Many derivative products trade nearly all day, including Sunday on the weekends. This is a huge benefit, as you can get into and out of trades at any time with plenty of liquidity. Also, derivatives trading is a great option for traders who have full-time jobs and need to trade in the evening.
5. Preferential Tax Treatment
Derivatives are essentially considered as bets in some tax jurisdictions and are taxable as capital gains and not income. This is a huge benefit for day traders who derive most of their income from the stock market. It is extremely important to consult your licensed tax advisor before making assumptions, as your jurisdiction may be different.
Dangers of Derivatives Trading
Derivatives trading can be extremely dangerous because it is highly leveraged. Like I said earlier, the low capital requirements are great – but this is only possible because you are taking on massive leverage to open a position.
Before new traders begin using leverage, they have to understand the mechanics of the stock market and what they are trading. Most retail traders just start trading whatever their favorite Twitter account is trading themselves. This always ends with disaster. To handle high leverage products you need at least a year of experience.
Another downside of derivatives trading is that commissions can rack up pretty quickly. This is especially true if you are a very active day trader.
Lastly, derivatives products are more complex than a stock company. Therefore, it takes more knowledge and understanding to become a successful trader in these markets.
Overall, the benefits of derivatives trading exceed the disadvantages. This is why more traders than ever are now making a career for themselves as independent traders from the comfort of their homes. This is also why options trading volumes have continuously hit new record highs in terms of volume, and in some cases exceeding the volume of the underlying securities.
If you are looking to start a career as a trader, we can teach you how to trade derivatives like a professional. You can start your career as a futures trader here, or check out a path in options trading here.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
