Derivatives are one of the most powerful tools you can add to your trading toolbox, however, you need to have a thorough understanding of strategy and risk before you dive into the derivatives market.
In a nutshell – a derivative is generally a contract rather than an asset. This contract directly relates to the asset, which is usually called the underlying and when you buy a derivative, you buy a promise to convey ownership of the asset, rather than buying the actual asset itself.
Liken it to buying a house… generally the legal terms of the contract for sale of a property are much more varied and flexible than the terms of actual property ownership. Well it’s this flexibility that appeals to investors.
Derivatives offer the same sort of leverage as a home mortgage.
When you buy a property you use a smaller amount of money than the full purchase price and in exchange for taking on the obligation of a mortgage, you gain control of the property.
Similarly, for a much smaller amount of money you can control much larger value of company stock then you would be able to without using derivatives.
Be warned though, this can work against you depending on whether the trade goes your way and what style of derivative you trade.
Sure, your potential returns would be far far greater than investing directly in the company if your view is correct, however if you got it wrong there are some derivatives that will actually multiply your losses instead.
Futures and Stock Options are two of the most commonly traded derivatives and rapidly growing in popularity are CFD’s.
A stock option contract gives the owner the right (but not the obligation) to buy or sell a particular stock at a fixed price on or before a given date, while the owner of a futures contract HAS A DEFINITE OBLIGATION to buy or sell the asset.
In the latter case, your potential losses can be unlimited whereas when you buy an option, the most you stand to lose is limited to what you pay to own the option. Hence your downside risk can easily be limited.
If your choice of derivatives is CFD’s then your potential losses are magnified sometimes 10 times over due to the margin component because you are actually trading with borrowed money.
For instance, you may start with $5,000 in trading capital but you can take out a $100,000 CFD position.
If the market moved significantly overnight and gapped against your position by say 10% then your total loss overnight would be $ 10,000. So you’ve lost $ 5,000 of your own money and you now owe your broker another $ 5,000!!!!
OUCH!Opportunities when trading the global markets are everywhere, but if you have wiped out your trading account then you won’t see a single penny of profits by sitting on the sidelines in negative territory.Our choice of derivative remains the stock option and several simple option trading strategies are a vital component of our trading toolbox.