Derivative trading: definition, types and strategies

Derivative trading is a popular way to speculate on, or hedge against, market movements. Find out the different types of derivative products you can use.

What is derivative trading?

Derivative trading is the practice of using instruments that track the underlying price of an asset to speculate on financial markets, rather than buying and selling the physical asset itself.

Types of derivatives

• Contracts for difference (CFDs) – these are agreements to exchange the difference in an asset’s price from when the position is opened to when it is closed
• Options – these contracts give the holder the right, but not the obligation, to buy or sell an asset at a set price on or before a set date of expiry
• Futures – these contracts are standardised agreements to exchange an asset for a set price on a set date of expiry
• Forwards – these are over-the-counter agreements to exchange an asset for a set price on a set date of expiry
• Spread bets – speculative bets on the future direction of a market’s price

Let’s take a look at the benefits and risks of each type of derivative instrument in more detail.

1. Contracts for difference (CFDs)

Contracts for difference, commonly referred to as just CFDs, are agreements in which two parties exchange the difference in a market’s value between the time the position is opened and when it is closed.

If you think a market will increase in value, you can buy a certain number of contracts on the asset, and if you think the market will decrease in price, you can sell it instead.

Your profit or loss is determined by the extent to which your prediction is correct.

For example, you open a long position on 5 gold CFDs at 1850, where each has a contract size of $10 per point of movement. That means you stand to make or lose $50 for every point of movement.

If the price increases to 1880, you’d make 20 points worth of profit – totalling $1000. However, if the price of gold falls to 1830, you’d have $1000 of loss on your hands.

CFDs are also a leveraged derivative product, which means you’ll only need to put down a fraction of the full value to open a trade.

Taking our gold trade as an example. The full value of that trade would be $9250 (5 x 1850) but if the margin requirement was 20%, you’d only need to put down $1850.

But it’s important to remember that the total of your position is calculated based on the full value – which means the profit or loss can be magnified beyond your initial deposit. That’s why a lot of CFD traders attach stop-loss orders to their positions to limit their risk to a known amount.

Learn more about CFD trading

2. Options

Options contracts are an agreement that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a set price – known as the strike price – on or before a set date of expiry.

An option’s value is determined by the difference between the underlying market price and the strike price at the time of expiry.

There are two types of options:

1. Calls – these options give the holder the ability to buy an asset or go long. They gain value if the market has risen to, or beyond, the strike price at the point of expiry
2. Puts – these options give the holder the ability to sell an asset or go short. They gain value if the market has fallen to, or below, the strike price at the point of expiry

The holder – or buyer – of an option will have to pay a premium to open their position, in exchange for a potentially unlimited profit and limited risk – as regardless of what may happen in the market, the position can be left to expire. This makes the premium the maximum loss an option holder will face.

The writer – or seller – of an option has a potentially unlimited downside, but they are paid the premium to take on this risk.

Learn more about options trading

3. Futures

Futures contracts are an agreement to buy or sell an asset on a specified price on a date of expiry. Futures are commonly used to trade commodities, as well as currencies and indices.

Like options, the value of a futures contract depends on the difference between the agreed-upon price of exchange and the underlying market price at the date of expiry.

For example, say a futures contract on WTI Crude Oil (US Crude Oil) with an expiry in August is trading at $65 per barrel. You think the price will rise beyond that price before expiry, so you buy the contract. If at the time of expiry, the price of WTI is $70, you’d be able to buy WTI at the futures price of $65 per barrel.  

Unlike options, though, there is an obligation between the two parties to exchange the asset – either by settling the position ‘physically’ if there is a tangible asset, such as a commodity or shareholder certificate, or in cash. This means that if your prediction was wrong, you’d still have to uphold your end of the bargain.

In our WTI example, had the market price fallen to $60 instead, you’d still have to pay $65 per barrel of oil.

Futures contracts are traded on an exchange, so they have strict specifications – unlike CFDs or forwards, which are tailor-made to the parties’ requirements.

For example, a standard futures contract for WTI Crude Oil is worth 1,000 barrels. That means buying at $60 would give you a total exposure of $60,000. But like CFDs, futures are usually leveraged, so you’d only have to put down an initial deposit to open a position.

Futures also have regular settlement windows. For example, expiry dates for oil futures are every month – while other contracts will have only a few dates a year. The date of expiry will always be referenced in the name of the futures market. For example, an oil futures contract that expires in August would be named ‘US Crude Oil (per 0.1) Aug 23’.

4. Forwards

Forwards are contracts between a buyer and seller to exchange an asset on a future date and at a specified price, or strike price. A forward’s value is based on the price of the underlying asset at the point of expiry.

Much like a future or an option, if a trader is using a forward to buy an asset, and the price is higher than the strike price at expiry, the forward will enable them to buy the asset for cheaper. But if the price is lower, the position would be at a loss, because the trader would need to buy the asset at a higher value than the going rate.

Forwards are most commonly used to trade currencies. Let’s say you wanted to go long on EUR/USD, believing it will rise in value from the current rate of 1.0890 within the month. You decide to buy a FX forward at the existing spot rate, with an expiry in one month’s time. If the market did increase to 1.0900, you’d have locked in the lower price. But, if the price fell instead, you’d be tied into the contract at a higher price.

5. Spread bets

Spread betting is a derivative that enables traders to speculate on whether a market is going to rise or fall in value – the profit or loss to the trade is determined by the extent to which that prediction was correct.

For example, if you bet that the Dow Jones (Wall Street) index will rise, putting on $50 per point of movement, and it increases by 10 points, you’d earn $500. But, if the Dow fell by 10 points instead, you’d lose $500.

Like a lot of other derivatives, spread bets are leveraged, so it’s important to manage your risk appropriately and never overlook the full value of your position.

For UK-based traders, the key benefit of spread betting over other derivatives is that it is completely tax free. That means no stamp duty and no capital gains tax.

Learn more about spread betting

Exchange-traded derivatives vs over-the-counter derivatives

Exchange-traded derivatives are those that are bought and sold in official marketplaces. For example, options that trade on the Chicago Board of Options Exchange, or futures on the Commodity Exchange (COMEX). They are highly regulated and standardised so that every contract is worth the same.

Over-the-counter derivatives are not standardised. They are made directly between two parties, or via an intermediary such as a broker, so they can be customised to suit the needs of a trader. Common OTC derivatives include forwards, CFDs and spread bets, but options and futures can also be traded OTC, although they’re not as popular as their exchange-traded counterparts.

How to trade derivatives

You can trade derivatives, such as spread bets and CFDs with City Index. We offer pricing on a huge range of markets – including commodities, forex, indices and stocks – as well as futures and options.

To get started, just:

• Open a City Index account, or log in if you’re already a customer
• Search for the market you want to trade in our award-winning platform
• Choose your position and size, and your stop and limit levels
• Place the trade

Alternatively, you can practise trading derivatives risk free in our demo account or learn more about how to trade an IPO

Derivative trading strategies

Derivative trading strategies outline exactly when and how to enter and exit any given trade. There is a wide range of derivative trading strategies that you can use depending on the product you’re using to trade.

For example, a CFD trading strategy will vary from an options trading strategy, as the timeframe changes – a CFD trade might be held less than a day, while an options trade can last months or more.  

Let’s look at a few popular ones in more detail.

Hedging with derivatives

Most derivatives are commonly used for hedging, a strategy designed to minimise risk to an existing position by opening an additional trade. That’s because you don’t own the asset, so you can go short on markets in the expectation they’ll fall in price too.

For example, if you own $1000 worth of Apple shares, but think the value of your holdings could dip briefly after a disappointing earnings report, you could go short on Apple shares with CFDs to offset the loss.

CFD trading strategies

CFDs are primarily used to take short-term positions, but CFD strategies can cover the longer-term outlook too.

For example, support and resistance trading is a popular strategy that involves taking a long position at a known point of support, ready for the market to break out, or a short position at a point of resistance, ready for a reversal.

Trading between lines of support and resistance can be a useful strategy whether you’re looking at a daily timeframe or weekly timeframe. The consideration is that there are additional fees for holding a CFD trade open overnight.

Spread betting trading strategies

Like CFD strategies, most spread betting strategies are based more on short-term momentum.

For example, trend trading is a popular strategy as it involves identifying the overarching direction a market is moving in and taking a position on the body of a trade – rather than finding the exact moment a movement starts or ends.

Options trading strategies

As options are considered a more advanced derivative, due to the sheer number of factors that influence market pricing, the strategies are also more involved. That’s why most options strategies are geared toward the more experienced trader.

Options are extremely popular due to their flexibility and capped risk for the holder. If markets move in your favour, you can execute the option. But if conditions are unfavourable, you can leave it to expire worthless.

For example, a long straddle is used when the trader is unsure of which direction the market will move in. They buy both a put and a call option, with the same strike price and expiry date, and then regardless of which way the price moves, they have a position ready to earn profit. The other would be left to expire worthless, and the maximum loss is capped at the premium paid.