What are derivatives? and why they’re a revolution for traders
Derivatives
trading!
What I believe has been the absolute market revolution since
shares.
Derivatives might sound complicated and something you would hear
from a professor or a know-it-all businessman – but
they're really not.
I am no academic or even remotely one of the smartest guy’s in
the world. And if I can grasp the idea and understanding of
derivatives, I pretty much guarantee you will too.
Also, if you want to take trading seriously and really make a
living with it, you’ll need to understand derivatives trading
sometime in your career.
That’s where MATI Trader comes in…
In the next few weeks, I’ll be sending you a series of articles on
everything you’ll need to know about CFDs and Spread trading
derivatives – Starting with this one…
Make sure you add us to your email address book and
set a reminder for every Monday at 7:30am.
Let’s start at the very
beginning.
What is a derivative?
– Collins English
Dictionary – ‘A derivative is
an investment that depends on the value of something
else’
When it comes to trading, a derivative is a financial contract
between two parties whose value is ‘derived’ from another (underlying)
asset.
You’ll
find that the derivative’s market price mirrors that of the
underlying asset’s price.
NOTE: As
there are a number of different derivatives you can trade nowadays,
we will ONLY focus on CFDs and Spread trading in the next few
weeks, as those are the only ones I trade with MATI Trader.
Why trade using derivatives?
The
absolute beauty about trading derivatives is that they are a cheaper
and a more profitable way to speculate on the future
price movements of a market without buying the asset itself.
You don’t get all the benefits
with derivatives
What’s
probably important to note with derivatives, is this.
When you buy a derivative’s contract, you’re not actually buying
the physical asset. You’re simply making a bet on where you expect
the price to go.
EXAMPLE:
When you buy actual shares of a company, means you’ll be able to
attend AGMs (Annual General Meetings), Vote and claim dividends
from a company.
When you trade derivatives on the underlying share, means you’ll be
exposed to the value of the shares and the price movements – and
that’s it!
As a trader, when you buy or sell a derivative, you’re not actually
investing in the underlying asset but rather just making a bet
(speculation) on where you believe the market’s price will head.
This gives you the advantage and opportunity to:
Buy low (go long) a
derivative of the underlying asset and sell it at a higher
price for a profit or
Sell high (go
short) a derivative of the underlying asset and buy it back at
a lower price for a profit
Remember when I said it was
cheaper and more profitable? You can thank margin
With
derivatives, you’ll normally pay a fraction of the price of the
total sum and still be exposed to the full value of the asset
(share, index, currency etc…)
The fraction of the price paid is called ‘margin’.
EXAMPLE:
To buy and own 10 Anglo shares at R390 per share will cost you
R3,900 (R390 per share X 10 shares).
To buy and be exposed to 10 Anglo shares using derivatives, and the
margin of the contract is 10% per share, means you’ll only pay R390
(R390 per share X 10% margin per derivative X 10 shares).
I’m sure you can see that with derivatives, you’ll be exposed to
more and pay less which will gear up your potential profits or
losses versus when trading shares.
This is why we call derivatives, geared financial instruments.
To understand this better, we’ll need to examine the very essence
of how derivatives work through the function of gearing, which
we’ll cover in more detail in the next coming weeks.
Or if you’d like to watch a complete video I recorded earlier this
year on how gearing and leverage works with live relatable
derivative examples, click here to start watching…
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