Derivatives, or how to speculate on price changes of an asset without holding it

With several trillion dollars traded daily, the derivatives market is ideal for speculators.

While most long-term investors prefer to hold the financial assets they are betting on directly, most short-term speculators prefer to use financial derivatives. They are then confronted with other speculators, but also with companies that have implemented hedging strategies.

What is a financial derivative ? Why trade derivatives ? What are the different types of derivatives ? Where and how can you buy them ?

Here is a comprehensive summary of the information you need to know to take advantage of the opportunities offered by derivatives.

What is a derivative ?

By definition, a derivative is a financial contract whose value depends on changes in one or more underlying financial assets. 

In some cases, the relationship between the value of the derivative and the price of its underlying asset will be linear or even symmetrical, while in other cases the relationship will be non-linear and more complex. Some financial derivatives such as futures and options will be traded on an organized exchange, while others such as forwards and CFDs will be traded directly between investors on an OTC market.  

Why buy or sell a derivative

Derivatives can be used for hedging strategies, speculative strategies and even arbitrage strategies.

Hedging with derivatives

Hedging strategies allow a company or an investor to protect itself from price variations in a given market by opening a position in the opposite direction to its initial exposure. For example, a mining company exposed to the risk of a decline in the price of an ounce of gold may use a derivative product whose price variations will compensate for its losses in the event of a drop in the yellow metal. Similarly, an investor holding an equity portfolio could use a derivative to offset the loss in value of his securities in the event of a crash.

Speculating with derivatives

Speculative strategies allow speculators to make money in the financial markets by betting on price changes in financial assets. While buying and selling these products directly allows you to bet on the rise or fall of prices, the costs can be significant. In order to avoid paying brokerage fees and high stock exchange fees, speculators generally prefer to use derivatives, especially since these products can allow them to set up more complex bets, especially by using combinations of options to bet on specific parameters: the “Greeks”.

Arbitrating with derivatives

Finally, arbitrage strategies allow investors to make money by exploiting differences in value between two financial products or groups of products whose prices should be identical. While low brokerage fees and trading flexibility are among the main advantages of derivatives, it should not be forgotten that they also allow investors to speculate on both the upside and the downside with leverage, thus reducing their capital requirements to a strict minimum.

The different types of derivatives

Although there are an infinite number of financial derivatives, it is possible to divide them into two main families and to mention the most well-known ones.

Derivatives traded on the stock exchange

Futures are standardized contracts traded on organized markets through a clearinghouse whose objective is to eliminate the risk of counterparty default. As the name implies, they are commitments to buy or sell an underlying financial product at a future date and at a given price. Options are contracts offering the right to buy or sell an underlying financial product at a given price at a future date (European option) or until a deadline (American option).

Over-the-counter (OTC) derivatives

Forwards are non-standardized futures contracts traded directly between companies and investors. Like futures contracts, they are commitments to buy or sell an underlying asset at a future date. CFDs (Contracts for Difference) are over-the-counter derivatives traded directly between brokers and their clients. They are relatively simple to operate, mirroring the price movements of their underlying asset and allowing investors to simply bet on the rise or fall of prices while benefiting from significant leverage.

Since the Sapin II Law, there are also limited risk CFDs for which the leverage is lower. Swaps are derivatives that allow two companies or investors to exchange the cash flows of an underlying financial asset for those of a second underlying financial asset. For a company, this usually involves exchanging variable flows (generated by variable interest rates) for fixed flows (generated by a fixed interest rate) in order to reduce its exposure to interest rate risk. For an investor, on the other hand, it is generally a matter of taking the opposite approach by accepting exposure to interest rate risk in exchange for the associated risk premium.

Derivatives, while sometimes complex in their operation, have revolutionized the world of finance and it would be unthinkable to imagine financial markets without them. To be successful in trading, you should at least take the time to understand how the simplest derivatives such as CFDs work.