Looking for different types of derivative contracts to enhance your trading? We’re impressed. This is some serious business.
Now that you’re interested in financial derivatives, you’re entering deep waters. Nominex’s deep blue sea is tremendously exciting, full of coral reefs, pretty little goldfish, and chests with treasure at the bottom.
This ocean also has in abundance killer whales (who regularly create astonishing price changes), loan sharks (who’ll charge you an arm and a leg for a $300 loan), and spectacular pufferfish*. Already guessed the metaphor? The answer is at the end.
How to get the treasures buried at the bottom and stay alive? If you want to increase your chances of taking home a prize, you need to study the sea’s deadliest predators and ways of evading them. Preferably all of them.
Dangers in the wild and wonderful world of crypto come in many forms and usually come out of nowhere. Borrowing money and then having your position liquidated (sometimes for external reasons). Trusting an exchange that goes poof-bye-bye with your money. Falling for a (sorry about this) phishing attack. Getting a lot of salty comments from Redditers and deciding this isn’t for you and not even starting.
It’s true, the world of trading is fraught with crime, punishment, pride, and prejudice. But the good thing is that learning is the ultimate power. Armed to the teeth with knowledge, you can avoid phishing attacks, dubious exchanges, beginner mistakes, bad strategies, and ultimately come out on top. How? Keep reading our blog.
One of the most fundamental things when it comes to trading strategies is knowing when to get in and when to get out, but learning what to trade could also prove to be one of the most significant choices. What are derivatives? Should you trade them? Are they any better than regular trading? Let’s find out.
Derivative contracts: the forbidden fruit
Derivatives, like gorgeous people when you’re married, are dangerous, tough to handle, and irresistible.
The answers are yes and yes. Not to the first and second questions but to the second and third. Like to live dangerously? Credit default swaps are usually associated with the famous banking crisis of 2008 but if used right they can be genuinely profitable, which is proven by the fact that everyone who’s anyone is using them.
In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. – Warren Buffett’s Berkshire Hathaway, a holding company in Nebraska.
“Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions to facilitate certain investment strategies.” – Also Warren Buffett’s Berkshire Hathaway.
How do they work?
There’s a reason why futures and options sound so philosophical. Thoughtful usage of these tools can make or break lives. Treat with caution!
A derivative is an agreement between two parties according to which they promise to transfer an asset (like stocks and bonds) or money on a specific date (or before) at a specific price. Advanced types of derivative instruments like forward contracts, call options, and credit default swaps will be examined in-depth in later articles.
For example, you want to buy a car suspension but you know that for your very expensive Ferrari the auto mechanic you trust will only be available in 3 months. Besides, you don’t have the money now.
Instead, you get an agreement with the auto dealership that they will sell you a shiny new Ferrari suspension in three months. The fact that they will sell it to you for a specific price means you won’t come to a dealership, find out the price rose, and your money isn’t enough (and the appointment is out of the window too). Risk hedging!
Derivative contracts are way cool. They offer advanced functionality (like Trailing Stop Orders you’ll find at Nominex), which are a little complicated, but they’re a lot easier than they may seem.
Actually, with TLC all trading is a lot easier and safer than everyone thinks, which is why Nominex is proud to be offering a range of functions you’re guaranteed to love, from a referral system with unlimited levels to earn from to an educations program that will surely eliminate all your questions, and frankly enviable support.
Accounting for derivative contracts
Derivatives are contracts with assets they’re bound to. By the way, owning types of derivatives doesn’t mean ownership of the assets in any way. Same as having dollars doesn’t guarantee you you can buy food (although, unless you’re in some exceptional circumstances like war or getting lost in the woods you will).
You can buy contracts and trade them in the same way you would trade these assets but derivatives are more convenient to handle and account for. Parties agree to exchange promises to buy or sell the underlying asset under specific conditions.
In a sense, all money is derivatives. You don’t want to keep your savings in chickens, so you keep dollars (crypto is even better). Dollars are easier to store. That’s their main advantage.
Derivatives like futures and swaps go one step further. You may have an underlying asset class such as (the easiest example, although there are far more) commodities and currencies.
If you’re a company and you’re buying something, you know in markets the prices of goods you’re after tend to go up and down, and the markets in crypto are extremely volatile. You want to protect yourself from risks if you’re concerned about the safety of your investment or want to make sure you can sell/buy something at a certain point in time.
Derivatives’ value is derived from the value of an asset. A futures contract is an agreement to buy or sell an asset at a specified date and a specified time. A company may want to protect itself from risk and lock in the price with a supplier so that they can purchase their goods at a certain price, which will enable them to calculate their profits easily.
Accounting for derivative instruments is a lot simpler and more efficient than, for example, running your business using Bitcoin. Imagine this: you’re running a company, and your workers only accept USD. You have enough BTC to pay their salary plus spend the New Year in New York in style, but a collapse in price means you’re now in debt. Ouch! This is where you should have used a derivative of some sort.
On that note, the world of crypto is soon to see stupendous smart derivative contracts. According to ISDA, hurdles are yet to be overcome like “complexity of the legal frameworks, the significant payment netting that occurs, subjective elements of the event of default provisions, as well as other costs, fragmentation risks, and technological issues”. But we’ll keep watching the developments with interest.
Recap: what makes a derivative?
- Collateral (the underlying asset)
- A small insurance payment
- An accord about a buy-sale at a specified time and price in the future.
Derivative contracts examples
We’ll keep things simple, since this is a rather complex topic, and give you just a couple of examples, just bear in mind that there are way more types of derivatives and underlying classes out there.
Futures contracts help save you from risks of rising or falling interest rates. Futures are an agreement about buying something in the, you guessed it, future.
The price is set. And so is the time. If you’re a turkey farmer and you want to sell your turkeys for the exact price they’re worth in a year but worry about the price going down, you reach an agreement with the local shop at which they will buy 100 turkeys from your in a year exactly at $30 each. If their price goes up to $50, you’ve regrets – but that’s better than having to sell them at $10, right? Futures.
Options, as the name implies, give you choices. In case with options, you have the right (but not the obligation) to sell or buy the underlying stock on a specific date.
The easiest way to think about it is if you have your pension money (or a part of it) in shares and you’re worried that they might plummet and ruin your plans, you can buy options, which will give you the right to sell them in 10 years at a specific price. If the price of the company you have shares in doesn’t plummet you don’t have to sell them.
But doesn’t that mean a risk for the other person, you say? For that reason, you pay the person you’re having an option contract with a monthly fee.
Intrigued? There’s far more interesting stuff at Nominex right now than people’s futures. Like their presents and demo tournament results. What, you haven’t heard about these yet? The games are already in full swing!
*By pufferfish we mean exchanges who appear to be several times bigger than they are but contain nothing but deadly poison which will destroy your funds and your willingness to trade again for a lifetime. Wowchies!