Trading 101 - What is a Derivative & why are they revolutionary?

Derivatives trading!

What I believe has been the absolute market revolution since shares.

Derivatives might sound complicated and something you would hear from a professor or a know-it-all businessman – but they’re really not.

I am no academic or even remotely one of the smartest guy’s in the world. And if I can grasp the idea and understanding of derivatives, I pretty much guarantee you will too.

Also, if you want to take trading seriously and really make a living with it, you’ll need to understand derivatives trading sometime in your career.

Let’s start at the very beginning.

What is a derivative?

– Collins English Dictionary –

‘A derivative is an investment that depends on the
value of something else’
When it comes to trading, a derivative is a financial contract between two parties whose value is ‘derived’ from another (underlying) asset.

Let’s break that down more simply:

A derivative is a
financial contract (CFDs, Spread Trading, Futures, Forwards, Options &Warrants)
Between two parties (the buyer and seller)
Whose value (the market’s price)
Is derived (depends on or comes from)
Another underlying asset (Share, index, commodity, currency, bond, interest-rate, crypto-currency etc…)

You’ll find that the derivative’s market price mirrors that of the underlying asset’s price.

Why trade using derivatives?
The absolute beauty about trading derivatives is that they are a cheaper and a more profitable way to speculate on the future price movements of a market without buying the asset itself.

You don’t get all the benefits with derivatives

What’s probably important to note with derivatives, is this.

When you buy a derivative’s contract, you’re not actually buying the physical asset. You’re simply making a bet on where you expect the price to go.

EXAMPLE:

When you buy actual shares of a company, means you’ll be able to attend AGMs (Annual General Meetings), Vote and claim dividends from a company.

When you trade derivatives on the underlying share, means you’ll be exposed to the value of the shares and the price movements – and that’s it!

As a trader, when you buy or sell a derivative, you’re not actually investing in the underlying asset but rather just making a bet (speculation) on where you believe the market’s price will head.

This gives you the advantage and opportunity to:

Buy low (go long) a derivative of the underlying asset and sell it at a higher price for a profit or

Sell high (go short) a derivative of the underlying asset and buy it back at a lower price for a profit

Remember when I said it was cheaper and more profitable? You can thank margin

With derivatives, you’ll normally pay a fraction of the price of the total sum and still be exposed to the full value of the asset (share, index, currency etc…)

The fraction of the price paid is called ‘margin’.

EXAMPLE:

To buy and own 10 Anglo shares at R390 per share will cost you R3,900 (R390 per share X 10 shares).

To buy and be exposed to 10 Anglo shares using derivatives, and the margin of the contract is 10% per share, means you’ll only pay R390 (R390 per share X 10% margin per derivative X 10 shares).

I’m sure you can see that with derivatives, you’ll be exposed to more and pay less which will gear up your potential profits or losses versus when trading shares.

This is why we call derivatives, geared financial instruments.

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Trade well, Live free

Timon
MATI Trader

Also my socials are below thanks to Trading View.