The derivative market has evolved and expanded since ancient times existing in various forms since the dawn of commerce. Primarily used as a way to hedge (insure) risk and by speculators looking to profit from price fluctuations, derivatives are one of the main types of financial instruments.
What is derivatives trading?
Put simply, a derivative is an instrument whose value is determined or derived from the value of another asset. That is to say that the initial value of the derivative depends on something else. The asset, which the derivative value is derived from, is called the underlying asset. Today there are innumerable iterations of derivatives, but they are primarily traded based on underlying assets of stocks, bonds, commodities, currencies, interest rates, and market indexes.
In the wake of the global financial crisis of the 2000’s much of the blame has been placed on derivative exchanges. There have been repeated calls for more transparency in the industry. This being said, derivatives markets are a critical component in the functionality of day-to-day activities for individuals as banks, corporations and governments would not be able to operate in the modern world without the ability to hedge risk.
Derivatives market history
Although modern derivative trading became widespread in the 1980’s, derivative trading basics have existed in one form or another for over 10,000 years. In ancient times tokens were used as a promise to deliver a certain quantity of a certain good at a given time. The price and timeframe were negotiated and both parties agreed to the terms. Variations of this type of agreement were utilized throughout Ancient Greek and Roman times primarily for agricultural commodities.
In the middle ages and colonial times bills of exchange, a written order that binds one company or individual to make a payment to another company or individual and a type of derivative, were used extensively to finance expansion, wars and exploration. A significant number of early exploration missions to the far East and the Americas were funded based on selling the rights to the goods that would be brought back from the expedition. Eventually these bills of exchange began to be traded as an instrument of value on their own as there was speculation on what the value of the goods would be at the time of delivery.
Modern electronic derivative trading has its roots in the early 1800’s when the increasing trade in agricultural goods in the USA led to the formation of the Chicago Board of Trade. The Chicago board of trade still exists as a derivative market today, now called the CME Group.
The primary function of derivatives was to hedge risk in agricultural products, until the 1970’s and the beginning of the computer age. With the advent of technology, pricing of the underlying asset and the ability to hedge risk became much more well defined and opened the door to active trading and the expansion of the derivative market. In 1992 the trade in derivatives became electronic, allowing for increased access to the derivative market and a global expansion of investors.
This access to capital increased the amount of assets which were traded in the derivatives market and eventually led to property being included. The connection between property and the derivatives market was the major cause of the global financial crisis of the 2000’s. As with most other things the derivative market is constantly evolving. The invention of blockchain technology and the subsequent introduction of Bitcoin and others has led to a massive derivatives market in virtual currency.
Derivatives trading explained
Derivatives are contracts between parties that specify certain conditions such as: maturity date, the price of the underlying asset and the contractual obligations of all parties. They are primarily used to insure (hedge) risk or for speculation (profit seeking).
A simplified example of how to trade derivatives in the grain market outlines the fundamental aspects of derivative trading. In a two-party grain contract, there is a seller (farmer) and a buyer (factory). In this exchange the farmer will benefit from a higher grain price and the buyer will be negatively impacted, however a farmer will be negatively impacted by lower prices. As neither party is willing to accept the risk of unknown future price, they can negotiate a price on a certain date that they are both willing to conduct the grain sale/purchase.
They will enter into a contract (future) which will specify the date and price that the sale will be conducted. The buyer (factory) has negotiated a call option, while the seller (farmer) has negotiated a put option. These contracts can then be traded with other parties. This is a basic example of a derivative trading and in modern times there are innumerable iterations and underlying assets involved in the derivative market.
Types of derivatives
Derivatives can be divided into two primary groups, over-the counter (OTC) traded derivative instruments and exchange trade derivatives.
Over-the-counter derivatives make up the majority of global trading and are characterized by being exchanged on a decentralised market where participants trade with each other directly. Dealers quote prices that they are willing to offer and the deals are done privately. As this pricing information is not publicly disclosed it can lead to severe swings in market prices as shifts in the market become apparent.
Exchange traded derivatives are comprised of similar instruments but are traded publicly on the open market with pricing and volume information readily available. The most common types of derivatives are:
Contracts for Difference (CFDs). A CFD is a contract between two parties, a client and a broker, which gives the opportunity for a trader to profit from a price fluctuations of the asset’s price without owning the underlying asset itself. It is calculated by the asset’s movement between the trade’s entry and exit price.
Forward contracts. A forward is a contract to buy or sell giving the option to conduct a transaction on a certain date, at a certain price. The profits and losses are realised based on the price movement of the underlying asset between the start and the end of the contract. Forwards are usually traded OTC, under the privately negotiated terms between the parties.
Futures contracts. A future evolves out of a forward contract and both derivatives share many common features. What makes futures differ is that they are standardised and traded on traditional stock exchanges, and therefore, subject to daily settlement.
Options. An option provides one party with a right (but not an obligation) to buy or sell an asset to the other party at a predefined future date at a settled price. The contract, which gives the option to sell an asset is called a put option. The contract, which gives the option to buy an asset is called a call option.
Swaps. A swap is another type of a derivative contract, which helps two parties to exchange cash liabilities or cash flows from two different financial instruments. One of the most common types of swaps is an interest rate swap.
The Bottom line
Although derivative trading does inherently carry a significant amount of risk there will always be attractive opportunities for investors to profit. They are constantly evolving with the virtual currency derivative instruments being one of the latest conceptualisations of this ancient form of barter.