What is derivative trading and how do I get started?

What is a derivative contract?

A derivative contract is a contract between two or more parties where the derivative value is based upon an underlying asset. Common underlying financial instruments include stocks, currencies, and commodities. The price of the derivative is determined by the price fluctuations of the underlying asset. Derivatives can be traded on an exchange or over the counter​ (OTC), which means trading through decentralized dealer networks rather than a centralized exchange.

What is derivative trading and how does it work?

Derivative trading is when traders speculate on the future price action of an asset via the buying or selling of derivative contracts with the aim of achieving enhanced gains when compared with buying the underlying asset outright. Derivative trading has grown in popularity since the 1980s, and investors can now trade derivatives on a range of financial markets including stocks, currencies, and commodities.

Traders can also use derivatives for hedging purposes in order to alleviate risk against an existing position. With derivatives, traders are able to go short and profit from falling asset prices. Therefore, they can use derivatives to hedge against any existing long positions.

Leverage with derivative trading

Trading with leverage​ on derivatives involves entering into a buy or sell position and speculating on which way their chosen market will move, using a reasonably small margin/deposit. Without the investor actually owning the underlying asset, their profits or losses will correlate with the performance of the market. However, leverage will cause these profits/losses to be magnified when compared with buying the underlying asset outright.

Risk management when trading derivatives

To help reduce risks in trading leveraged derivatives, it is important to plan a trading strategy​​ in advance. A popular risk-management tool traders can use when trading with leverage is a stop-loss. By implementing a stop-loss order​ to a position, a trader can limit losses if the chosen market shifts in an unfavourable direction. However, it is important to be aware of potential risks, such as the market experiencing a negative short-term fluctuation, which could activate the stop loss order before the market conditions improve again. Explore our risk-management​ guide to learn more about how to protect your money in trading.

Types of derivatives to trade

There are several types of derivative products that you can trade, with each of them having significant differences in their details, risks and benefits. CFDs, forwards, futures and options are some of the most popular types of derivatives among traders.

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CFD trading

CFD trading​ (contracts for difference) is another leveraged derivative product that enables traders to speculate on short-term price movements. It is a contract between two parties to exchange the difference between the opening and closing prices of a specified financial instrument at the end of the contract. You buy or sell a number of units for a particular asset depending on whether you think the movement of price will rise or fall. You gain multiples of the number of CFD units you have bought or sold for every point the price of the instrument moves in your favour. In the opposite scenario, when the price moves against you, you will make a loss. You can trade CFDs on many financial instruments with us. Learn more about understanding CFDs​, the costs involved and gain insights from a variety of examples.

Benefits and risks of trading CFDs

There are a range of benefits of trading CFDs​. One example is that you can trade on the price of a product that is falling as well as rising. Therefore, you can aim to benefit from going short and selling as well as buying opportunities. Through periods of short-term volatility, many investors trade CFDs as a way of hedging their existing portfolios.

There are however, risks of trading CFDs​ to be aware of, for example gapping. Gapping occurs when the price of an asset suddenly moves from one level to another, without passing through the level in between. Traders may not always have the opportunity to place a market order between the price levels. Gapping arises as a result of market volatility. It is possible to limit the risk and impact of market volatility by applying an order boundary or guaranteed stop-loss order. Another aspect to be aware of is CFD holding costs​. These are charged to your account if you hold positions on certain securities overnight past 5pm New York time.

Forward trading

Forward trading is a transaction between a buyer and seller to trade a financial asset at a future date and at a specified price. The forward contract’s value is based on the stability of the underlying asset and it includes the agreement of the asset price and trade date. Forward trading is an alternative to purchasing an asset at spot price. We offer forwards contracts on commodities, indices, treasuries and foreign exchanges.

Benefits and risks of forward trading

An advantage of forward contracts is that the agreement to buy and sell at a specific price in the future ensures that your position is protected from unfavourable market movements. However, this can also act as a disadvantage because the price can fluctuate in a favourable manner and the asset can become more valuable. As you are locked in at a specified price, you will not be able to take advantage from this movement in price.

Options and futures

An option is an agreement between two parties that gives the buyer the right, but not the obligation, to purchase or sell an asset at a set price on or prior to a specific date. Options can be traded on several types of underlying securities such as stocks, ETFs, and indices. Forex options​ work in the same way but are specific to currency pairs and are driven by factors such as interest rates, inflation expectations, and geopolitics.

Futures trading​ is the trading of financial instruments as contracts via a futures exchange. It is an agreement between parties that an asset will be exchanged at a predetermined price and date in the future. One party is obligated to purchase the asset once the futures contract expires whilst, when expired, the other party is obliged to produce the asset.

It must be noted that we do not offer the opportunities of trading options or futures. However, our trading platform does offer you the opportunity to trade forward contracts, which are an underlying form of futures, on a wide range of financial markets and assets.

Derivative trading strategies

With derivative trading, having a trading strategy is vital in deciding your entry and exit points. It is important to fix a plan that is built to achieve gains, limit losses and manage risk as much as possible.

Short-term traders​ such as day traders​​ focus on following trends that arise throughout the day in short periods with the aim to gain from short-term price movements. There are several well-known strategies for short-term traders, such as scalping​​, which is where traders aim to make a profit from small price fluctuations, before and after executing a trade. Long-term trading involves holding on to a position for longer periods. Long-term traders make decisions based on fundamental analysis​​ that mainly focuses on how the market will look in the future. Position trading​​ is a popular long-term strategy, which enables traders to hold a position for a long period of time. Without concerning themselves with shorter-term trend movements, position traders’ focus is on the long-term objective.

Explore some of the most common trading strategies​ that exist, which could be extremely helpful in building your own trading plan​​.

• Day trading for beginners

How to trade derivatives in the financial markets

You can trade on thousands of financial instruments with CMC Markets via derivatives, which are explained in further detail below.

Derivative trading in the stock market

You can trade on the price movements of stocks​ through CFD trading. Our trading platform offers you the opportunity to trade derivatives on thousands of shares. You can also trade derivatives on exchange-traded funds (ETFs). These are investment funds that hold a collection of underlying assets, such as shares, commodities and bonds. Learn more about ETFs​​​ and how you can trade on them with our CMC platform.

Currency derivatives trading

With CMC Markets, you can get exposure to over 330 currency pairs by way trading CFDs, which is the largest forex market offering in the industry².

Commodity derivatives trading

Traders can also trade CFDs on a wide range of commodities, which are categorized into either hard or soft varieties. Examples of hard commodities includes natural resources like gold and oil, whereas soft commodities are agricultural products, like wheat and coffee. Discover more about how to trade commodities​​.

How to trade in the derivatives market with CMC Markets

Open a live account today to start trading on the underlying price movements of financial instruments. Before placing your trade, make sure you have understood and followed risk-management guidelines. Apply any risk-management orders, such as stop-loss orders, and confirm your trade.

Derivatives trading platform

Our award winning platform has a wide range of exclusive trading tools and technical features that we offer to aid your derivative trading strategies.

Once you have registered for an account, you can start to trade on over 11,000 financial instruments, which are displayed in our Product Library. We also have some pre-determined categories that are exclusive to the platform, such as the biggest share risers and fallers of the day in price. Our ‘Hot Products’ feature is updated hourly with financial instruments whose recent trade volume has increased significantly versus the monthly average.

Summary

In summary, derivative trading has grown in popularity, with investors being able to trade derivatives on a vast range of financial instruments, such as stocks, currencies, and commodities. Open a live account today to start trading CFDs on our CMC Markets trading platform. You can also benefit from our news and insight tools to keep track of news about your preferred assets and industries.