How To Learn Derivatives Trading: Derivatives initially started out as financial instruments used to secure the supply of commodities and facilitate trade as well as to insure farmers against price fluctuations. But, over the years, the use of derivatives increased and currently, many traders use these instruments as means to earn lucrative gains. But trading in derivatives will require you to have a strong foundation of the types of derivative instruments, and how these instruments work.
In this article, we will guide you through the various types of derivatives and how to learn derivatives trading.
What Are Derivatives?
Derivatives are financial contracts that derive their value from an underlying asset. These contracts are entered between two or more parties to be exercised at a predetermined date and predetermined price. The underlying asset can be stocks, bonds, commodities, or currencies.
Derivative contracts can be categorized into various instruments such as forwards, futures, options, and swaps. These contracts help traders and investors to speculate on the price of the security or hedge their existing portfolios.
Know More: What is Derivative Trading? Futures & Options Explained
Types of Derivatives
Before knowing how to learn derivatives trading, it is important to understand the various types of derivative instruments that exist, so that you can choose the contract that is best suited for you
1. Forward Contracts:
A forward contract is a private agreement between two parties to buy and sell an underlying asset at a fixed date and at a predetermined price. The price at which the underlying asset is to be transferred is decided at the time of entering the contract.
Forward contracts are regarded as over-the-counter (OTC) instruments because they are not traded on a centralized exchange. Since these contracts are traded OTC, the terms in the contract are customizable.
The contracts are formed to tailor to the particular requirements of the parties involved. As there is no centralized exchange or clearinghouse involved when the parties enter into a forward contract, it can lead to a risk of default by one of the parties in this contract.
These contracts are used by large institutions or individuals to protect themselves against price changes or to speculate on future price movements.
Forward contract is the oldest form of derivatives which serves as the conceptual basis for other types of derivatives that we see today
2. Futures Contracts:
Futures contracts are similar to forward contracts with some added upgrades. Just like the futures contract, these are formal agreements between two parties entered through a standardized exchange to buy and sell an underlying asset at a fixed date and at a predetermined price. Unlike forward contracts, future contracts are not customizable as they are traded through a standardized exchange.
In these contracts, the parties involved are required to pay the margins upfront as collateral to ensure that both parties fulfill their obligations under the contract. Thus, it eliminates the counterparty risk between the parties and ensures that both parties fulfill their obligations.
The participants enter these contracts when they expect the future price of the underlying asset to change from the price they are currently trading at. Based on the parties’ price expectations, they enter into a long position or short position in the contract.
Some of the commonly traded futures contracts include Agricultural Futures, Energy Futures, Metal Futures, Currency Futures, and Financial Futures.
These contracts are one of the most commonly traded contracts in the stock market.
Here, the traders will require a large number of margins in order to enter the contracts, but executing trades in these contracts is comparatively simple than executing trades in options.
3. Options Contract:
Just like the futures contract, an options contract is an agreement between the parties to buy and sell an underlying asset at a fixed date and at a predetermined price. But the difference here is, the buyer of the options contract will have the right but not an obligation to execute the options contract on the day of the expiry. But the seller on the other hand is obligated to honor the contract if the buyer chooses to exercise his right.
For this benefit, the buyer of the options has to pay an amount to the seller of the options which is called a premium. For receiving the premium from the buyer, the seller will forfeit the right to execution of the contract.
The options contract can further be divided into a call option and a put option. In a Call option, the buyer of the contract will obtain the right to buy the underlying asset. In a Put option, the buyer of the options contract will obtain the right to sell the underlying asset. The prices here are pre-determined at the time of entering the contract.
Though the concept of options trading looks simple and beneficial to options buyers, it deals with the complexity of the options Greeks. The options greek include gamma, delta, theta, vega, and rho which greatly impact the winning chances of the options buyers.
Read More: Which Is More Profitable Futures Or Options Contract?
4. Swap Contracts:
Out of all four derivatives contracts, swap contracts are one of the most complex contracts. It is a contract privately entered between two parties to exchange cash flows in the future as per the pre-determined rate.
These swap contracts consist of various types of which interest rate swaps and currency rate swaps are commonly executed contracts.
These contracts cannot be traded like the futures and options contracts in the stock exchange. Usually, these contacts are entered by big businesses and financial institutions and are not entered by retail investors.
How To Learn Derivatives Trading?
Out of the four types of derivatives, futures, and options contracts can be traded by retail investors through the stock exchange. Now we will see how to learn derivatives trading in these segments:
- Reading Books:
Reading books can give you a firm foundation for understanding the principles and strategies involved. They offer a systematic way to study the subject that makes sure you don’t overlook any important ideas or concepts. There are various books on derivative trading that are written in simple language that can be easily understood by beginners.
Read More: Best Books on Derivatives – Top 6 Derivatives Trading Books!
- Online Courses:
For people who are not a fan of reading, online courses can be a great alternative for learning derivative trading. You can select the courses that focus on particular subjects or areas of interest, and you can skip over information that you already know.
At FinGrad, we provide more than 65 courses and webinars on investing, trading, and personal finance instructed by qualified professors, and have more than 44k learners on our platform as of the date and it has helped them better understand the Financial Market.
- Mentors:
Finding an experienced derivative trader to mentor you is another great approach to learning derivative trading. A mentor can give you insights that he/she has gained through their experience. They can also provide you with guidance that can help you improve your skills and knowledge which can help you be successful in derivative trading.
- Practice With a Demo Account:
One of the best ways of learning derivative trading is by actually trading in the live market and for this, you need not actually require the money to trade live in the market. There are many trading platforms that provide a demo account through which you can trade in the market using virtual money. This way, you can test your trading skills, backtest various strategies, and note where you went wrong in the trades before you start trading with real money.
In closing
In this article, we discussed the meaning of derivatives and their types and understood how to learn derivatives trading.
On a closing note, it is important to note that even though you learn how derivative trading works, you are still bound to make mistakes in the market. Thus, it is important for you to start off a small amount and place stop losses so that you don’t lose a huge amount in times of wrong analysis.
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