Derivatives are financial instruments that we hear of only when the economic chronicles conquer the first page.
In fact, the category of derivatives is a container in which there are “objects” with very different characteristics. In general, a derivative is a financial instrument, usually a contract whose value depends on a financial or a real asset that takes the name of underlying asset.
Typical examples of underlying assets are: a share, an exchange rate between two currencies, oil, gold etc…
We have to keep in mind the difference between the derivatives traded on regulated markets and those traded outside the market (OTC – Over the Counter).
Derivatives traded on regulated markets have standard specifications defined by the market authorities. Those are elements such as the timing of trading, the minimum price movement, the closing prices and trading hours.
Derivatives are basically classified into:
- future (a contract to buy or sell quantities of a commodity or financial instrument at a price with a delivery set at a specified time in the future) and
- option (a contract which gives the buyer the right to buy or sell shares of the underlying asset at a price on or before a specific date).
The problem with derivatives and their risk lies in the fact that it is possible to lose much more than the invested amount. This makes it sometimes difficult to understand the operation of these financial instruments.
It is important to understand the high risk of derivatives that allow you to control the risk itself. Between the derivative instruments offered by financial markets, we will focus on futures, which are also those mainly used for trading.
Futures contracts are standard and therefore negotiable, unlike the custom ones (OTC) that are not tradable on the market because of their heterogeneity.
Futures are traded on regulated markets and there are specific rules in their negotiation and creation. They are very standardized: each element of the contract is defined in a standard contract.
Buying futures means to purchase to maturity date and set the price of the underlying asset. This can be either an activity, such as a commodity (wheat, gold, metals, coffee, etc…) or a financial asset (for example currencies).
Futures can be classified into:
- Index futureswhere the underlying asset is represented by a stock index;
- Stock futuresis a contract by which buyer and seller agree to exchange at a maturity date an amount of shares at a fixed price at the maturity of the contract. The buyer agrees to buy futures and the seller to sell the shares;
- Currency futureswhere the unit of trading of each contract is a fixed amount of a foreign currency (forex market);
- Commodity futureswhere the underlying asset is a commodity. In this case the price is not simply the prediction of a market price, but also includes the carrying charge (storage costs, insurance, etc …).
It is important to consider, however, the leverage that we have already explained in a previous article. For this reason it is important to fully understand the characteristics of each futures contract before deciding to invest in these financial instruments.
We suggest, therefore, for those who decide to trade futures, to have available funds related to the value of the contract. Although it is possible to use leverage, brokers sometimes make it seems that glitters are always gold.