New investors who search for online information about derivatives often turn up all sorts of complex data about mathematical topics, particularly calculus, that have nothing to do with the way the term is used in trading. In the investing world, a derivative is simply any of various kinds of legal contracts between parties in which the outcome is based on the price performance of a given asset within a set time frame.
The good news is that in practice, trading these kinds of securities is much simpler than the wordy, formal definition suggests. For example, most people have at least heard of the two most popular derivative investments, namely options and CFDs (contractsfordifference). They’re the top two, with futures close behind. What are the key facts that everyone should know about derivative investments? Here’s a quick cheat sheet for traders and investors who want to start off with clear, helpful concepts before putting their own money at risk.
Futures contracts are one of the oldest kinds of financial contracts in existence, having been around for more than 2,000 years. In ancient times, farmers used the written contracts to assure a market for crops that had not yet been planted. A typical futures contract today is quite similar. Two parties agree on a fixed price for a set amount of a commodity, like wheat, to be exchanged on a precise future date. Both parties commit to the deal regardless of which direction actual prices. All other derivative investments are set up in the same way. For the most part, only sophisticated investors buy and sell futures contracts, which is why simpler, more direct derivatives like CFDs and vanilla options are much more popular these days.
With a CFD, the buyer does not own the underlying asset but simply makes a prediction about its price direction. CFDs are sold on a spread basis, so the built-in fee is part of the initial purchase price. After that, there are no fees or commissions for this kind of trading. If, for example, you believe the price of ABC Corporation stock shares is going to fall, you could execute a CFD sell contract via an online trading platform. Then, if you predicted correctly, you’d book a profit on the contract based on the amount of the price decline.
Options give you, the holder, the right to either buy or sell 100 shares of a named stock at or before a stated future date, and at a specific price. Note that options are only used on traditional securities like stocks and are classified as puts (the right to sell), or calls (the right to buy). You pay a premium at the time of entering into the deal, and that’s you cost of trading these vehicles. Options that include no complex mathematical features, but only allow the holder to buy or sell, are referred to as vanilla options, or plain contracts. By far, the modern CFD and vanilla option are among the most widely traded derivatives of all.