Derivatives Markets Definition and Examples

Introduction to Derivatives

Explanation of derivatives market
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Derivatives are tradable products that are based upon another market. This other market is known as the underlying market. Derivatives markets can be based upon almost any underlying market, including individual stocks (such as Apple Inc.), stock indexes (such as the S&P 500 stock index) and currency markets (such as the EUR/USD forex pair)

Types of Derivatives Markets

There are several general derivatives markets, each containing thousands of individual derivatives which can be traded.

Here are the main ones day traders use:

  • Futures Markets
  • Options Markets
  • Contract For Difference (CFD) Markets

Trading Derivatives Markets - Futures

May day traders trade the futures market. This is because there are many different types of futures contracts to trade; many of them with significant volume and daily price fluctuations, which is how day traders make money. A futures contract is an agreement between a buyer to exchange money for the underlying, at some future date. For example, if you buy/sell a crude oil futures contract, you are agreeing to buy/sell a set amount of crude oil at a specific price (the price you place an order at) at some future date. You don't actually need to take delivery of the crude oil, rather you make or lose money based on whether the contract you bought/sold goes up or down in value relative to where you bought/sold it. You can then close out the trade at any time before it expires to lock in your profit or loss.

Trading Derivatives Markets - Options

Options are another popular derivatives market. Options can be very complex or simple, depending on how you choose to trade them. The simplest way to trade options is through buying puts or calls.

When you buy a put you are expecting the price of the underlying to fall below the strike price of the option before the option expires.

If it does, you make money, if doesn't, then you will lose the value (or some of it) that you paid for the option. For example, if XYZ stock is trading at $63, but you believe it fall below $60, then you can buy a $60 put option. The put will cost you a specific dollar amount, called the premium. If the stock goes up, you only lose the premium you paid for the put. If the stock price goes down though then your option will increase in value, and you can sell it for more than what you paid for it (premium).

A call options works the same way, except when you buy a call you are expecting the price of the underlying to rise. For example, if you think ZYZY stock, currently trading at $58 will rally above $60, you can buy a call option with a strike price of $60. If the stock price rises, your option will increase in value and you stand to make more than you paid (premium). If the stock drops instead, you only lose the premium you paid for the call option.

Trading Derivatives Markets - Contract for Difference (CFD)

Contract for difference (CFD) markets are offered by various brokers, and therefore may differ from one broker to another.

Typically they are simple instruments though, labeled with a similar name to the underlying. For example, if you buy a crude oil CFD, you are not actually buying into an agreement to buy crude oil (like with a futures contract) rather you are just entering into an agreement with your broker that if the price goes up, you make money, and if the price goes down you lose money. A CFD is like a "side bet" on another market.

With most CFD markets (check with your broker), if you believe the underlying asset will rise, you buy the CFD. If you believe the underlying asset will decline in value, then you sell or short the CFD. Your profit or loss is the difference between the prices you enter and exit the trade at.

Final Word on Derivatives Markets

Depending on a trader's trading style, and their capital requirements, one market may suit one trader more than another. Although one derivative market isn't necessarily better than another. 

Each market requires different capital amounts to trade, base on the margin requirement of that market.

Futures are very popular with day traders--day traders only trade within the day and don't hold positions overnight. Options and CFDs are more popular among swing traders--swing traders take trades that last a couple days to a couple weeks. 

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