Derivative Guide: Choosing the Right Contract Based on Trading Strategy
Financial markets have a plethora of derivative contracts that each serve their own distinct purpose. Futures and options are widely known contract standards that run on exchanges, but most forex traders are more familiar with CFD’s – an easier way to leverage yourself in the market without the strict funding requirements as options and futures. As the crypto market develops more and more, traders will look to enter positions through these CFD’s listed on reputed brokers like EasyMarkets.
The Emergence of Derivatives
Derivatives were created and initially used as an instrument that mitigated risk and reduced uncertainty for for those in the business of extracting natural resource like oil and gas, farmers of mass-produced crop, and parties with an obligation to receive a certain amount of foreign currency sometime in the future. Today, derivatives are mainly used a means to absorb more risk, leading to hyper stimulation of financial markets across the globe, led by the surge in popularity for derivatives.
Futures and options are the two most common derivative contracts in the market. Futures are a standardized contract to enter an agreement where one party’s obligation is to buy a security/commodity/currency at a particular price and the counter-party must sell it. Simply put, it is absolutely necessary for the transaction to take place at the pre-determined price on a pre-determined date.
Options are more flexible from a buyers perspective and come in two varieties – calls and puts. Calls allow the buyer the right, but not the obligation, to buy the underlying asset on the contract while a put allows the buyer to right, but not the obligation, to sell the underlying asset based on stipulated strike price.
As the most common forms of opening a position in a derivatives market, these two instruments have surged in popularity since the mid-2000s, creating a new wave of traders and speculators who offer more liquidity and better price discovery in financial markets. CFD’s emerged in the 1990s when it was used as a method of creating an easy equity swap by two traders at UBS. Since then, they have become retail focused instruments, allowing brokers to earn a better spread than futures and options and giving customers the ability to enter positions without colossal margin deposits and funding.
Difference Between CFD’s and Standardized Derivatives
Future and options have much more stringent liquidity requirements as they are publicly traded on exchanges and involve a significant degree of counter-party risk. CFD’s are OTC instruments between the trader and their broker, with no counter-party.
Standardized derivatives can be settled for the difference in value via cash or physically settled to exchange the required quantity of the underlying asset. CFD’s involve no physical settlement and pure speculative instruments that get settled in cash rather than an exchange of the underlying. There are several benefits to trading CFD’s with a well-reputed broker like EasyMarkets from a profitability and risk management perspective, the most obvious of which is the flexibility it offers traders to diversify or change their approach and position in the market.
The spread of CFD contract is wider than futures, but that is a necessity considering the broker is the other side of the contract. Moreover, liquidity is public and much more prominent on futures and options, which plays a massive role in putting downward pressure on the spread. While a wider spread implies less favorable terms for the traders, the overall transaction costs are much lower than any exchange-traded derivative contract.
Knowing Which One to Pick
Different situations require different strategies, so a trader focused on milking the best opportunity cannot limit themselves to singular type of derivative. For example, a trader who thinks a certain event coming up is bound to induce massive volatility will benefit much more from the option market rather than futures or CFD’s. If a trader believes the market will head in a particular direction, they can implement this through options, but its is much simpler to take a position in the futures or CFD market. A CFD is perfect for cryptocurrency as it works best as a speculative tool; even the CME Bitcoin future contracts are pseudo CFD’s as they do not physically settle.
A CFD allows cryptocurrency traders to swiftly enter and exit positions without requiring a certain amount of market liquidity, which has a great impact on trading profits.
Futures and CFD’s are ultimately similar contracts with a few varying technicalities. Banks, investment management firms, and hedge funds that leverage the derivative market are more likely to trade futures over CFD’s as they take dynamic positions and continuously update their hedge strategy. The advantage of futures of derivatives is the ability for producers to hedge. An oil producer can hedge their forecast of next months oil production by going short on a futures contract i.e. taking the position of the seller.
A buyer in the hedging market would be a manufacturing firm that utilizes copious amounts of oil and is looking to lock in their buy price for their future supply. Companies tend to favor certainty of a particular price instead of waiting for an opportunity to buy at the lowest possible price.
Ultimately, it all boils down to whether the goal is hedging or speculation. CFD’s are superior in comparison to futures when it comes to speculation, but they do not play a role in price discovery as it is an OTC product with volumes that are difficult to estimate. As a retail trader, the cost of taking a position is extremely low, making CFD’s the optimal contract standard to act on a directional bias. When the assumption is that volatility will increase with no directional bias or an outlook consisting of a short term bearish bias and long term bullish bias, options are better suited to successfully implement the strategy.
Learning about the types of derivative contracts from swaps to CFD’s is an imperative part of finding a strategy that aligns with your goals. Making sure you use a trustworthy and reputed broker is just as important as actually trading. With a surge in cryptocurrency derivative adoption, any trader who takes their craft seriously must be well versed with derivative contracts and be able to choose the optimal standard based on their strategy and outlook.
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