How Do Financial Derivatives Work? The Basics

It’s easy to get overwhelmed by all the different terms and concepts associated with trading, stock markets, and shares. The environment seems to have a language of its own, driven by the experts in the field that constantly come up with new ways to manipulate the market.

One of the most common terms you’re likely to hear as you develop your skills is financial derivatives. A derivative is essentially a kind of financial security with a value that comes from a specific group of assets or relies upon a set of assets as a benchmark. The product is a contract between multiple parties, and it takes its price from various fluctuations in the underlying assets. The most common underlying areas involved in this region are commodities, currencies, stocks, and indexes. Usually, you’ll buy these things through a broker.

How Do They Work?

There are many different kinds of financial derivative in the trading world. For instance, you may decide to get involved with something called a contract for difference, commonly known as CFD trading. This basically an arrangement made between multiple people where the differences between the closing and opening prices are settled in cash. With this kind of trading, there’s no physical ownership and no goods to consider.

CFDs are a little complicated to get your head around as a beginner in the marketplace, which means that many people prefer to start with something a little simpler. You can trade derivatives on an exchange, just like you would a standard security or stock. However, there’s also the option to get involved with over-the-counter marketplaces too. The OTC solutions have a greater sway over the market, and generally come with more counterparty risk. This means that there’s a chance someone in the transaction could default.

Why Are They Used?

Most of the time, a derivative is a way of hedging a position, speculating on the region or directional movement of an asset, or giving leverage to specific holdings. The value in these purchases come from the unpredictable fluctuations of the asset underneath. Originally, many people relied on these assets as a way to ensure that the balanced exchange rates for goods moving internationally. When national currencies differ so much, it was important for global spenders to have a system that would account for the differences.

Derivatives are currently based on a wide selection of transactions, with various additional uses to consider. There even derivates based on the weather, that are used as a financial hedge to protect against bad weather affecting commercial farm harvests. This makes this particular landscape very versatile for those interested in diversifying their portfolio. A speculator who thinks that the euro will increase in value compared to the dollar, for instance, could profit by accessing a derivative that increases in value at the same time of the euro. The investor doesn’t need a portfolio presence or holding in the asset underlying in the trade.