Derivatives are highly rewarding instruments that more and more traders are choosing over other kinds of financial instruments. Even though there are some Financial Services who think that derivatives have more risks than benefits, it’s hard to deny that many other investors have made a fortune out of these contracts.
There are many kinds of Funding Methods derivatives. For instance, there are forwards contracts, futures contracts, options contracts, swap contracts, and CFDs.
However much these contracts appear to be different from each other, they do have other great similarities that make them fall under the category of being derivatives.
In this article, we’ll deal with the characteristics that can be found on derivatives as financial instruments.
Contract Obligations and Dates
The very first thing that you will inevitably notice about derivatives is that they deal with the “contract” of ownership of the underlying assets. That means that the parties involved in the contract do not actually own the underlying asset from which the price of the contract has been derived. Rather, they’re entering into an agreement with another party.
And when it comes to agreements, there will be duties that one party has to fulfil. There are contracts wherein you are obliged to buy or sell the underlying asset once the contract expires. However, there are also other contracts that do give you the right to buy or sell the underlying asset, but do not impose any obligation on that matter, meaning you don’t have to buy or sell it if you don’t want to.
Another obvious characteristic of derivative contracts is the dates. You and the other party typically agree on the price of the underlying asset at present, but you push through the trade in the future.
And as with dates, the most important date to keep your eye on is the expiration date of the contract. This is because the contract becomes worthless once the expiration date arrives.
This necessitates quick action from the parties if they want the contract to be fruitful since they won’t be able to reap anything after the expiry.
This feature very much sets derivatives apart from other securities like stocks and bonds, which do not have any expiration date and maintains its value throughout. The only thing about the prices of such assets is the fluctuation of their prices, or volatility, which greatly becomes less of an issue with derivative traders.
In derivatives trading, only one of the parties can gain something, while the other has to lose something, making it a pure zero-sum game for traders. Upon entering a derivatives contract, the two parties involved with the trade are practically agreeing to bet against each other.
For the point of comparison, when a stock in the stock market rises in value, all investors holding the stock win. It’s the opposite of the zero-sum game.
This characteristic makes derivative trading a little bit riskier than other trades, if you count in the fact that many derivative traders use huge amounts of leverage for every trade.