What is derivative trading?
15:51, 25 March 2019
Derivatives opened up a new world of trading for everyone when they became a dominant feature of global commerce in the 1980s. Ever since, these financial instrument have dramatically reshaped the face of today’s global business.
What exactly is derivative trading? Let’s dive in and figure out what derivatives are, where they came from and how to trade them.
What is derivative trading?
Derivatives are financial instruments whose value is ‘derived’ from an underlying asset. Derivatives can be anything from an equity share, commodity, index, currency or interest rate.
The concept of derivative trading is actually rather old. The first proven example of a derivative transaction happened around 600 BC. Back then, an ancient Greek philosopher and mathematician, Thales of Miletus, became the world’s first derivative trader. He predicted a bumper harvest season of olive oil based on the meteorology observations and his knowledge of astronomy. Thales positioned himself to profit from rising oil prices by negotiating “call options” on olive oil presses for delivery in the spring.
Today, derivatives have become so popular because they are based on the monetary value of an asset rather than the tangible asset itself. It gives traders and investors a unique opportunity to trade currencies, commodities and stocks without an actual need of buying them.
Derivatives can also be used with leverage, which provides the ability to take a more significant position with a smaller amount of initial capital – maximising both the potential profits and potential losses. Even a small movement in the price of an underlying asset can result in a large difference in a derivative’s value.
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Types of derivatives
There are various types of derivatives that can be traded. These all have unique characteristics that distinguish them from one another and are used by traders for different reasons:
How to trade derivatives
Derivative trading is divided into two categories: exchange-based and over-the-counter (OTC) trading.
An exchange-traded derivative is a standardized financial instrument that is traded on a regulated exchange with transactions completed through a centralized source.
An over-the-counter (OTC) derivative, on the contrary, is traded off the exchange. The terms of a non-standardised contract privately negotiated and traded between the parties involved in the decentralised market.
Nowadays, this type of derivative trading is gaining more popularity: even big financial clients, such as commercial banks and hedge funds, frequently buy OTC derivatives from investment banks.
The main difference between these two is standardization versus customization. Exchange contracts are highly standardised, whereas the OTC contracts are the flexible private agreements with terms tailored to suit both parties.
One market may suit one trader more than another, depending on a person’s trading style and their capital requirements.