What is Financial Derivatives Trading?

When financial analysts start talking about swaps, options and futures, it can be unsettling for those of us who are less initiated in financial terms. The words themselves are familiar, but they seem to have taken on entirely new meanings! The truth, however, is that their intended meanings in financial contexts aren’t far from their common usages, nor are they very difficult to understand. All of these terms refer to financial derivatives, and the first step in understanding financial derivatives’ meaning is appreciating the reasons they were invented in the first place. As we will see, the reasons were eminently practical.

Nineteenth-Century Grain Dealers

For a start, take note that financial derivatives are not some newfangled product of our technological age, like cryptocurrencies or NFTs. Back in 1865, farmers and merchants in the grain trade realized they needed a way to protect their businesses from sudden price changes in their commodity. In their minds, there must be a way to stabilize the prices agreed upon in their deals, so that abrupt price shocks wouldn’t interfere with business. What if they could draw up a contract stipulating that a grain purchase would take place at a specified time and at a specified price? This way, the deal would be protected from unwelcome price fluctuations. This is, essentially, what a forward or futures contract is meant to accomplish.

Coca-Cola

If we look at a modern-day, multinational corporation like the Coca-Cola Company, we see they are exposed to a similar sort of risk in the prices of corn, which they use to make their product. They’re also exposed to foreign exchange risk, since they have to transfer their revenues from locations all around the world, where sales are made, to their home base. Their anticipated earnings could be significantly impacted by swings in the exchange rates between the currencies of those locations, on the one hand, and those at home, on the other. To ease the nerves of their shareholders on this score, the company trades in financial derivatives like forward contracts, commodity futures contracts, and option contracts.

Coca-Cola is not unique in this regard. The majority of the world’s 500 most valuable companies use financial derivatives to mitigate the different kinds of risk they face. Companies with exposure to oil, in particular, find it necessary to hedge against hikes in oil prices.

When do Companies Use Financial Derivatives?

But how do these types of financial derivatives work to protect against the various kinds of risk in the markets? Option contracts – as per their name – give you the option or opportunity to buy or sell a security at a fixed price within a set time period. If you’ve purchased the right to buy the security, it’s called a “call option”, whereas the right to sell is called a “put option”.

Since Coca-Cola’s revenues would be eroded by a hike in corn prices, they can buy a call option on corn, such that, in the event corn prices surge, company losses will be compensated by the increased value of the call. In effect, this means that Coca-Cola takes opposite positions on the same commodity. On the one hand, their business model depends on corn prices staying tame, but on the other, they own a financial instrument that appreciates in value when corn gets more expensive.

Similarly with regard to fluctuations in forex rates: The company could “insure” its foreign-sourced revenues against depreciation by buying financial derivatives that appreciate when exchange rates turn against them. In these ways, Coca-Cola can give their shareholders an idea of what they expect to earn with some level of confidence.

Trading in Financial Derivatives

Scaling down from corporations to individuals trading on the financial markets: Financial derivatives (put options, in this case) can be used to protect a trader’s portfolio against depreciation in one of its securities. But here we come to one of the other things that make financial derivatives so handy, aside from the function of hedging against risk. Most of the derivatives trading in the world, in fact, is done with this end in mind: speculation. Companies often choose to use financial derivatives to speculate on price movements in the markets. For instance, JP Morgan earned $512 million in the first three-quarters of 1993 in this way. But individuals can do it too.

Let’s say I want to trade online in corn, but I don’t believe prices are going up. On the contrary, I believe they’re headed for a serious dip. Can I open a deal that’s designed to work in my favour in the event corn prices drop?

Financial derivatives have the power to fill this need. Take, for instance, an instrument that has been growing increasingly popular in recent years: CFDs (contracts for difference). If I buy a corn CFD, I’m not buying any actual corn at all, but, rather, a contract with my brokerage that relates to two things: the price of corn at the time I open my deal, and its price when I choose to close the deal. In the event corn prices fall in the interim, my earnings will, in fact, increase – on the condition I opened a “sell” deal on the commodity. This is the type of CFD deal suited to those who expect a downturn in the market.

For others, who are more optimistic about market conditions, it’s also possible to open a deal in the traditional format (such that earnings depend on a surge in prices, rather than a drop). Such traders would open a “buy” deal on the commodity. Either way, you won’t have to take delivery of any actual bushels of corn. We see, then, that derivatives give you the power to trade in the price contingencies surrounding commodities, rather than the commodities themselves.

The Power of CFDs

But CFDs have other powers too. They allow you to trade in markets that, otherwise, might be barred from you because of cost considerations. You might not want to spend twenty-five thousand dollars on purchasing a Bitcoin, but CFDs let you trade in the Bitcoin market on your own financial scale. Similarly to the case of corn mentioned above, if you believed Bitcoin prices were about to shoot up, you could open a “buy” deal on the coin for the sum of money of your choice. You could equally open a “sell” deal if you believed prices were about to do the opposite.

From a single CFD account, you could actually trade in any, or all, of the major financial markets – from cryptos to commodities, and forex to ETFs. All that’s needed is to sign up with a reliable online CFD brokerage and deposit money in your trading account. The easy, convenient access to a variety of markets from a single platform is one of the things that enhances the appeal of CFDs. But there’s another thing about them that may be even more appealing.

What is Leverage

“The key benefit of derivatives over securities”, says Asher Rogovy of Magnifina, “is leverage”. Leverage gives you the power to open a large-sized deal, while only having to lay out a fraction of the cost from your own pocket. Normally, somebody with a balance of $1,000 in their trading account would be unable to open a deal worth $1,001. But let’s say, for example, your CFD brokerage offers leverage of 30:1 on the EUR/USD forex pair, and that you have a strong conviction the US dollar is going to strengthen against the euro. You could turn your position on the pair into a sell deal worth 30 times your account balance: namely, $30,000. This means that, in the event the dollar appreciates by 0.8% against the euro, your gains will equal, not 0.8% of $1,000 ($8), but 0.8% of $30,000 ($240).

Leverage is made possible by borrowing funds from your broker, which must, of course, be paid back afterwards. This means your net earnings will exclude the sum you borrowed. It also means that, in the event prices don’t go your way, you will still have to repay your debt. This added risk should be taken into account before deciding to make use of leverage in your trades.

Wrapping Up

Since financial derivatives offer the power to hedge against many kinds of risk, demand for them keeps on growing. It’s even possible, these days, for companies to use them to hedge against changes in the weather that would work against their business models.

And when it comes to online trading in instruments like CFDs, demand for financial derivatives just keeps on growing too. With the increasing interconnectedness of global markets, more and more people want to expand the range of their trading activities. Additionally, the chance to enter into a variety of markets at comparatively low cost, while greatly magnifying the size of their trading positions, is proving irresistible.