Derivatives are extremely useful when you participate in price action investing. In a nutshell, derivative investors want to transfer some risks from the underlying asset to another party. There are many ways to do that, and the following are the most popular derivatives to help with that goal.
Options are derivatives for investors to hedge risk or to speculate by taking additional risk. When you buy a call or put option, you get the right or the obligation to buy or sell shares or futures contracts at a predetermined price before or on the expiration date.
Trader trade these contracts on exchanges, which clears them centrally. That means there’s liquidity and transparency in the process. And these two things are crucial when investing in derivatives.
The following are the factors that determine an options contract’s value:
- Time premium, which decays as the option nears the expiration date. When the time premium is completely consumed, the contract becomes worthless.
- Intrinsic value, which tells whether the contract is in or out of the money.
- Volatility, which refers to wild swings, or lack thereof, in the underlying asset’s price.
Single Stock Futures
A single stock future (SSF) is a contract to deliver 100 shares of a certain stock on a certain expiration date.
The market price depends on the underlying security’s price on top of the carrying cost of interest, minus dividends paid over the course of the contract.
Trading this derivative requires lower margin when you compare it to buying or selling the underlying security itself.
The following items best describe SSFs:
- They are a cheaper way to buy a stock
- They are a cheap way to hedge open equity positions
- They protect long equity positions against volatility or short-term declines in the underlying asset’s price
- They provide exposure to specific economic sectors
A stock warrant gives you the right to buy a stock at a certain price at a certain date. Just like call options, investors can exercise stock warrants at a fixed price.
Upon issuance, the warrant’s price is always higher than the underlying stock. However, it carries a long-term exercise period before they expire.
And when you exercise a stock warrant, the company issues new common shares to cover your transaction. This is different from a call option, where the call writer is the one to provide the shares if the buyer exercises the option.
Stock warrants are also typically traded on an exchange. However, the volume can be low, which in turn generates liquidity risk.
Contract for Difference
A contract for difference, or CFD, is a deal where a seller has to pay a buyer the spread between the current stock price and value at the time of the contract if the value rises.
On the flipside, a buyer has to pay the seller if the spread becomes negative.
The purpose of this derivative is to let investors speculate on price movement without having to own the underlying shares.
CFDs are not available in the United States but they are offered in other countries such as Canada, Germany, France, Japan, the Netherlands, Singapore, South Africa, Switzerland, and the United Kingdom.
The key to success is awareness. That’s why you need to check Finance Brokerage educational websites available. And you can choose the one that suits you the best in the Online Trading Courses offered.