Why New Traders Prefer to Begin with Trading Derivatives

The financial markets are naturally volatile. Supply-demand dynamics, geopolitical developments and even the weather can move asset prices. And prices can move in either direction, up or down. Consider a farmer who wants to secure a price for their produce before the harvest. So, even if the price declines by the time they sell their crop, they will receive the pre-determined price. This is exactly why derivatives were initially created. To lock in future prices. For traders, waiting for the market to move up and sitting on the sidelines while missing opportunities in a bear run can seem counterproductive. 

While derivatives are a great way for beginners to get into trading, they have their particularities that need to be understood. Read on to explore trading styles, strategies, benefits and what to watch out for when trading derivatives.

What are Derivatives?

Derivative instruments allow you to explore the opportunities that arise with price movements, without directly owning the underlying asset. They are a contract between a buyer and seller, and their value depends on the underlying asset. This could be a single asset, a group of assets, or a benchmark index.

The added advantage of trading derivatives is that you can explore opportunities in either direction of price movement.

How are Derivatives Traded?

Derivatives are contracts between two parties. A trader and a broker or a seller and a buyer. They can be traded over the counter (OTC) or on an exchange. 

Why Do Beginners Prefer Trading Derivatives?

New traders are often drawn mainly due to the potential for magnified returns and the relatively low initial capital requirement. However, it is crucial to understand that these very factors also make derivatives significantly riskier than traditional stock trading.

Leverage and Higher Potential Returns

Derivatives require a relatively small initial deposit, known as margin, to control a large value of the underlying asset. This leverage magnifies any profits but also multiplies losses. If the underlying asset’s price moves favourably, the percentage return on the small capital invested can be much higher than a direct investment in the asset itself and vice versa.

Trade in Any Market Direction

Derivatives allow traders to trade both rising and falling markets. Unlike traditional stock markets, where short-selling can be complicated and have unlimited loss potential, derivatives provide a more direct and defined way to speculate on a price decline.

Lower Initial Cost

These instruments tend to be more capital-efficient compared to buying the underlying asset outright. To gain exposure to an asset, you only need to pay a fraction of the total contract value. Trading derivatives can also sometimes have lower brokerage and statutory charges than trading equivalent volumes of stocks.

Flexibility and Range of Strategies

Derivatives, especially options, offer a wide variety of strategies. They can be used to gain exposure to various asset classes, including commodities, forex, stocks, indices and cryptocurrencies. Plus, they facilitate hedging and risk management.

Types of Derivative Instruments

Understanding the different types of derivatives can help you choose the most suitable one for your trading strategy.

Futures

These are binding contracts between two parties to buy or sell the underlying asset. The money and goods are exchanged at a price and future date mutually agreed upon at the time of signing the contract. Futures obligate both the buyer and the seller to honour the contract. 

Options

Options are similar to futures but are more flexible. They grant the parties the right but not the obligation to buy or sell. There are two types of options:

1. Call Options: The buyer gets the right, but not the obligation, to buy by a certain date.
2. Put Options: The seller gets the right to sell without the obligation to do so, and within a set timeframe.

Contracts for Difference 

CFDs are most popular among day traders. A CFD is a contract between you and the broker. While trading CFDs, you speculate on the direction of price difference. CFDs mimic the price movements of the underlying asset. Depending on the direction in which the price moves, you either receive or pay the price difference between the beginning and end of the contract.

CFDs work a little differently from other derivative instruments. For instance, you buy 10 CFDs (each valued $5 per point movement) on the S&P 500 at 4,000. When the index rises to 4,050, you can close the trade. The broker then pays you:

50 points x $5 x 10 contracts = $2,500.

There could be some deductions for transaction or swap fees.

Understanding Leverage

Derivatives are often traded with leverage. Leverage helps amplify the size of the position you control. You only pay a small upfront amount, while the rest is funded by your broker. For instance, a leverage of 1:10 means that for every $1 you invest, you can open a position worth $10, with the broker funding the remaining $9. As mentioned earlier, leverage amplifies both your potential profit and potential loss. This is why risk management is essential while trading derivatives.

Risk of Margin Calls

Leverage entails the risk of a margin call. If your account balance goes below the required minimum for the size of the position you control, your broker or the clearing house will notify you (margin call). If you fail to fulfil the requirement with a cash deposit or securities, your position may be partially or fully closed, depending on the terms of using margin.

Strategies for Trading Derivatives

Here are a few strategies you can begin with to explore derivatives trading:

Price-Action Trading

Price action traders use “naked” price charts, meaning they focus primarily on the price movements without complex technical indicators or algorithms. They analyst price charts, especially candlestick charts, to identify support and resistance levels, trends and patterns like head and shoulders to make buy or sell decisions.

News Trading

Geopolitical news, economic releases and corporate earnings reports can move the markets. So, news traders follow such announcements to capture the ensuing market volatility. For instance, a hike in interest rates by the Fed could strengthen the US dollar. You can choose to trade before, during, or after the news release.

Hedging

CFDs also work as hedging instruments. For instance, if you open a long position on the Nasdaq 100, you can hedge it with a short CFD on the index.

To Sum Up

• Derivatives are contracts whose value is derived from an underlying asset.
• Beginner traders prefer trading derivatives due to lower transaction costs and the ability to use leverage.
• Common types of derivatives include futures, options and CFDs.
• Leverage amplifies potential profits and losses, which necessitates risk management. 
• Derivatives can be used for various trading strategies.

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