Derivatives are among the most powerful investment vehicles out there. They’re very flexible, and they allow you to use tons of different strategies when investing.
About Derivatives
Basically, derivatives are contracts that use underlying assets to derive their value. This underlying asset, meanwhile, can be an asset that holds value.
That means you can use derivatives on stocks, currencies, commodities, and even cryptocurrencies. Thus, traders can speculate on the price of those assets with more flexibility.
Apart from those, derivatives offer other benefits.
Leverage
This is one of the most powerful tools an investor or trader can use to maximize his/her potential profits.
When you use leverage on derivatives, even the smallest price movement in your favor can mean large profits. You expose yourself to a much greater value than what your capital can control.
Liquidity
Markets for derivatives are very liquid. For instance, take a look at the futures markets. These contracts trade every day and therefore traders benefit from high liquidity.
There are always buyers and sellers present in the marketplace. That means you can place your market orders pretty quickly.
Low Commissions and Costs
The fees that you have to pay when trading derivatives are usually very low. That means you can spend more on your trade and lesson charges and commissions.
However, this may depend on the type of broker you are using. If you’re using a discount online broker, fees can be as low as $5 per trade. Full-service brokers, on the other hand, may charge more than $50 per trade.
Diversification and Hedging
Of course, you cannot put all your money in one basket. You want to diversify your portfolio as much as possible. Derivatives are great with that.
Derivatives are also useful when it comes to hedging. You can protect yourself from sudden and unexpected market movements by using contracts to lock in interest rates, or prices, for instance.
Types of Derivatives
Another great benefit of trading derivatives is that you can choose from different choices. The four main types of derivatives are forwards, futures, options, and swaps.
Forwards
These contracts are the simplest kind. Basically, forwards are agreements to buy or sell the underlying asset at a certain time in the future, with a certain price set in the present.
You and the other party will trade directly with each other, meaning there’s no intermediary using this derivative. Other derivatives trade on exchanges.
Futures
Futures contracts are very similar to forwards. The difference is that these derivatives trade on exchanges.
That means there are standards to follow, and the exchange serves as the intermediary between the parties doing the transaction.
Options
Options are derivatives that bind one party to the terms of the contract, while let the other party have the right but not the obligation to buy or sell a certain asset at a certain price in the future.
There are two types of options contracts. The call option gives you the right but not the obligation to buy a certain asset in the future, while a put option gives you the right but not the obligation to sell an asset in the future.
Swaps
And last but not the least, swaps. As the name suggests, the parties in this derivative swap something as part of the contract.
Swaps let you and another party exchange your cash streams or rates for a certain purpose. For instance, one entity may agree to swap a fixed interest rate with a floating one, if that’s more beneficial for the party.
