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Explaining What Derivatives Are

The main types of derivatives and how they are traded

Derivatives are a kind of contract that is used in trading. A financial derivative contract’s value is determined or derived from the value of another asset. The asset or security is known as the underlying asset. This article will teach you everything you should know about derivatives.

What are Derivatives?

Derivates have their value determined by an underlying asset or group of assets. The most common types of underlying assets are currencies, bonds, stocks, and commodities. The value of these underlying assets keeps fluctuating according to the market. This fluctuation of value makes you a profit or loss in derivatives.

Profiting from derivative contracts is based on the premise that the underlying asset’s value will rise in the future. Derivative contracts explicitly outline the terms under which the investor and the other party will respond to changes in the underlying asset’s value in future periods.

It is used in both finance and investing. Instead of trading actual physical assets, derivatives only derive their values from these underlying assets. It works kind of like a guarantee that you will eventually purchase the underlying asset at some point in the future.

The person selling a derivative contract doesn’t have to have ownership of the underlying asset. The contract can be fulfilled by giving the buyer enough money to purchase the underlying asset at the current value. The seller can also give the buyer another derivative contract to balance out the value of the first one. It is much easier to trade derivative contracts instead of trading actual assets themselves.

Different Types of Derivative Contracts

Trading Terminology

Here are some ways people trade derivatives:

Over the Counter: This is when individuals or companies that know each other trade derivatives. The transaction occurs through an intermediary like a bank or a brokerage-dealer network. This is the biggest market for derivatives.

Exchanges: Derivatives are traded on public exchanges like the Chicago Mercantile Exchange. These contracts have standardized terms with discounts and premiums. These contracts are much more liquid than OTC contracts, making them useful for hedging.

Different Types of Derivatives

Now that we know where and how to trade these contracts, let’s look at the main kinds of derivatives.

Futures: Futures are standardized derivative contracts that allow two parties to trade a certain asset at a predetermined price and future date. The buyer must purchase, and the seller has to sell the asset at the agreed date and price regardless of what the actual market value of the underlying asset may be at the time. These contracts are traded at a stock exchange and are standardized.

Forwards: Forwards are similar to futures as in, both parties must perform the contract. The difference is that they are not traded at exchanges and are not standardized, making them a little riskier than futures trading. These contracts can be customized to suit the requirements of both parties on the contract.

Options: Options are derivative contracts that give buyers or sellers the right, but not the obligation, to purchase or sell an asset at an agreed price on a specified date. They are similar to futures except that the parties are not obligated to purchase or sell the underlying asset. It is just an ‘option’ if they want, they can.

Swaps: Swaps are exactly what the name suggests. These are a kind of financial derivative that allows two parties to trade or ‘swap’ any kind of cash flow with another. These contracts are also not traded in exchanges and are usually private agreements traded OTC.

Written By

Riley is a finance, lifestyle, and entertainment writer living in San Diego. He received his bachelor's degree in Journalism and Multimedia from the University of Oregon. His work has been featured in many finance and lifestyle publications throughout the US. When he is not writing, Riley enjoys reading and hanging out at the beach with his dog, Miles.

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