So how exactly does one make money trading derivatives? It doesn’t sound very easy, but in fact, it’s quite simple. Follow a few simple rules of the game, educate yourself and pick a strategy. Then profits will follow. Before we get there, it’s important to understand what a derivative is.
Table of Contents
- What Is a Derivative?
- What Is the Most Common Way to Trade Derivatives?
- What Is Derivative Trading Example?
What Is a Derivative?
A derivative is also known as a financial security. The derivative itself is a contract between two or more parties. And the derivative derives its price from fluctuations in the underlying asset.
In this context, the term “security” refers to a financial instrument that is both fungible and negotiable; while holding some type of monetary value.
It represents an ownership position in a publicly-traded corporation via stock, a creditor relationship with a governmental body or a corporation represented by owning that entity’s bond or ownership rights as defined by an option.
The Value and Price to Make Money Trading Derivatives
A derivative’s value depends on or is derived from an underlying asset or group of assets referred to as a benchmark.
So what price does a derivative depend to make money trading derivatives? The derivative derives its price from fluctuations in the underlying asset.
Why Do We Trade Derivatives?
For many reasons. You can make money trading derivatives so why wouldn’t you want to? For some it’s just preference. Or on the other hand, you might have a smaller account and you want to use the leverage they offer.
Depending on the type of derivative, you can use them for risk management, speculation, and leverage.
What Is the Most Common Way to Trade Derivatives?
Derivatives commonly trade OTC (over-the-counter) or on an exchange. On the whole, we mainly trade derivatives OTC. However, one major downside of OTC-traded derivatives is their high potential for counter party risk. For those of you unfamiliar with counterparty risk, let me explain.
Counterparty risk is the danger that one of the two parties involved in the trade might default. And the answer as to why comes as no surprise. The trades happen between two unregulated private parties.
Conversely, if counterparty risk is a concern with you, stick with exchange-traded derivatives. Fortunately, exchange-traded derivatives are not only standardized but heavily regulated.
Common Forms of Derivatives
Did you know that the derivative market is a growing one and offers products to fit nearly any need, budget or risk tolerance? With everything from futures to forwards, swaps, and options, anyone with a little bit of training can make money trading derivatives.
Let’s break it down with a few examples.
Let’s Talk Futures Derivatives
Futures are exchange-traded derivatives —also known as futures—are contracts that lock in the delivery of a commodity or security in the future at a price set today.
Traders utilize futures contracts for many reasons such as to hedge their risk or even speculate on the price of an underlying asset.
Both parties (the buyer and seller) of the futures contract must fulfill their contractual obligations on the settlement date.
Regardless of the price at expiration, the buyer must buy, or the seller must sell at the pre-determined price.
What Is Derivative Trading Example?
Let’s move on to a real-life example of how someone makes money trading futures derivatives. On November 6th, 2019, my company purchased a futures contract on oil. We’re anticipating an increase in demand in December; and an increase in price. We’re being wise and wanting to lock in a price before they go up. The contract, which expires on December 19th, 2019, costs me $62.22 a barrel. Our oil futures contract hedges our risk against a rise in price as the seller is obligated to deliver the oil to us at $62.22 a barrel come December 19th, 2019.
Sure enough, oil prices rose to $80 on December 19th, 2019. Unfortunately for the seller on the other side of the contract, they have to deliver the oil to me at $62.22 a barrel.
At this point, I have one of two options. I can accept the oil delivery from the futures contract’s seller. But what if I no longer need it? Given that I have no use for the oil, I can sell the contract before expiration and keep the profits. How awesome is that!
In the scenario above, it’s possible both the buyer and the seller of the oil futures contract were hedging their risk or hedging their bets. We’re both trying to minimize the risk of being wrong; or incurring loss by pursuing two courses of action simultaneously.
My company needs oil in December, but I’m worried prices will skyrocket, so I buy a long position; hedging my bets. Conversely, the seller could be an oil company worried about falling oil prices.
Consequently, they want to eliminate that risk by selling or “shorting,” a futures contract that fixed the price in December.
We also have another possible scenario. What if both the buyer and seller of the futures contract were speculators?
Both with the opposite opinion about the direction of December oil. If both were speculators, it’s unlikely they would want to deliver or have to accept barrels of oil at their home.
As speculators, they have a ticket out of jail card, so to speak. Luckily, they can end their obligation to buy or deliver the underlying commodity. They accomplish this by closing or “unwinding” their contract before the expiration date with an offsetting contract.
Have I lost you yet? Don’t worry; I’ll explain this in detail below.
For example, let’s say the futures contract for West Texas Intermediate (WTI) oil equals 1,000 barrels of oil. What if the price of oil rose from $62.22 to $80 per barrel?
For starters, the trader with the long position-the buyer (me)- in the futures contract would have profited $17,780 [($80 – $62.22) X 1,000 = $17,780]. Yay!!! Conversely, the trader in the short position—the contract seller—would have lost $17,780.
What Happens at Expiration?
Not all futures contracts get settled at expiration by delivering the underlying asset. Who wants 1000 barrels of oil showing up at their doorstep? Not me, thanks. Because of this, most derivatives are cash-settled.
To summarize, the gain or loss in the trade shows up in the trader’s brokerage account. Along the same token, many Futures contracts are cash-settled.
Some of these include interest rate futures, stock index futures, and even volatility and weather futures.
Can you make money trading derivatives? While at a glance, trading derivatives may seem complicated, it doesn’t have to be. Now I only talked about futures derivatives on oil. But you can easily trade options contracts on stocks like Facebook. One of the ways to limit risks with derivatives is by trading spreads, such as call credit spreads. I would look into them if you’d like to get more into the world of options.