A Beginner’s Guide to Derivatives

A Beginner’s Guide to Derivatives

When you’re just starting out as an Invest Diva, one of the first things that will really make an impression on you is how many different ways to invest there actually are. If you’re a true beginner, chances are you hear “investment” and think “stock market.” This is the case for many of us, at least. But as was conveyed in our past look at different types of investments for women to consider when just starting out, there are actually plenty of different methods — both within the stock market and outside of it.

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One type of investment that we want to dig into a little more deeply here is derivative trading. To recap, a derivative security is a financial contract or product that a derives its value from an asset. In other words, derivative trading does not involve the exchange of the asset at hand itself, but rather deals that revolve around that asset. To expand on this basic example, consider some specific types of derivative trading that are popular today:

Futures Contracts – Futures contract are perhaps best explained through commodity trading, where it’s particularly easy to illustrate examples. A futures trade, fundamentally, is a contract via which an investor agrees to buy an asset at a specific price at a specific future date. So, for example, a woman entering into a futures contract with crude oil might agree to buy 1,000 barrels of oil at $45 apiece at the end of 30 days. In most cases, the same woman would then agree to sell 1,000 barrels of oil at the end of that contract, so as to profit off of the price difference. The idea is for value to increase in the interim, such that the investor acquires 1,000 barrels of oil worth $50 apiece at a price of $45 each. In that hypothetical, she would pay $45,000 on her original contract, and then immediately sell back the oil for $50,000 at the new price, netting $5,000 total.

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Options – Options trades work in almost the exact say way that futures do, with the key difference being that investors have the “option” of either fulfilling a contract or walking away from on at any point during its duration. So, using the oil market example from above, if an investor agreed to an options contract to buy 1,000 barrels of oil at $45 each, and saw the price reach $55 10 days later, she could execute the contract to net a significant profit. On the other hand, if the price remains close to $45 for too long, she can also walk away from the contract. Given this structure, options trading is seen as a lower-risk derivative technique.

Contracts for Difference – While it doesn’t tend to get quite as much attention as options and futures markets, contract-for-difference trading (or CFD trading) is another similar method. Often conducted in stock share and currency markets, CFD trading involves agreements based on price differences over time. In other words, an investor can set up a CFD trade in which she agrees to receive the difference in a stock share price between when the contract ends and when it began. If a share price is at $50 when the CFD is opened, and the investor liquidates a “buy” contract when it is worth $60, she nets $10 per unit of CFD. Similarly, a “sell” CFD (betting on a loss) would have the same result if the share price fell from $50 to $40.

Hopefully these examples convey how derivative trading differs from other forms of investment. They are investments based on contracts and arrangements revolving around different assets, as opposed to the purchase of the assets themselves. And there are a few specific benefits associated with this kind of trading:

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Lower Risk – To be clear, there is no guaranteeing that derivative trading is low risk. But with specific regard to potential asset crashes, it can feel like the less risk option. When an investor takes possession of an asset or share, there is always potential for the asset’s value to plummet due to unforeseen events (such as the pandemic we’ve experienced in 2020!). This can result in significant losses without swift action. In derivative situations, however, investors can be better able to abandon would-be losses of this nature.

Leverage – Leverage is a trading tool by which investors are able to make deals with more money than they actually put in. So, for example, a leveraged trade could allow an investor to purchase a $500 position even if she only contributed $100. This is a high-risk/high-reward strategy, as it can amplify both gains and losses, but it’s something a lot of investors favor, and it’s a common option in derivative trading.

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Trading Style – One look at the advantages of derivative trading mentioned “style of trading” in reference to the fact that derivatives are transparent and not infested with insider trading issues. We would add, however, that style also comes into play when it comes to managing these investments. In the simplest terms, derivative trades require less constant attention than some other forms of trading. This can make them appealing to people who are too busy to turn investing into a job. Women busy with work and/or raising families may appreciate this aspect of derivatives in particular.

This conveys most of the basics concerning derivatives! As is always the case when you enter into a financial arrangement, you’ll want to do more research of your own if you decide to enter these markets and conduct investments of this nature. But it’s always best to understand the basics, and we hope this article has helped you to do just that.

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