Derivative financial instruments: futures, options - what is the difference

Derivatives are securities whose market value depends on the price of the underlying asset. In simple terms, derivatives are derivatives of underlying instruments. They are issued in the form of contracts containing the right or obligation (depending on the type of derivative) to sell or purchase the underlying asset at a fixed price within a certain period.

The derivatives market is a derivatives market because contracts have fixed expiration dates. Earnings on such contracts can bring considerable profits if the trend is moving in the right direction. Instances of losses are also common, since working with derivatives requires considerable experience. Today we will look at the types of derivative securities, look at examples of transactions and talk about the risks that are largely inherent in derivatives.

The history of derivatives

The history of the emergence of derivative contracts goes back to the distant past. Even in ancient Babylon, merchants resorted to the help of lenders in order to equip trade caravans. If the product was successfully sold, the loan was repaid on time. A high interest rate was paid for using the loan, which was due to the increased risk.

In 17th-century Japan, farmers collecting rice to sell received advance payment in exchange for an empty basket. The basket served as a commitment to supply rice in the future. The basket was handed over in a specially designated place. The price of the crop included the risk of the seller and the buyer.

Another example of early derivatives is the tulip mania in Holland in the 16th-17th centuries. At that time, the demand for tulip bulbs significantly exceeded the supply, and contracts for the supply of bulbs were concluded long before they were planted. Further, the bulbs that were in the ground were sold at a fabulous price. This is how futures contracts arose - obligations for the supply of bulbs. The collapse of tulip mania was due to the fact that prices for the underlying asset - tulip bulbs - reached incredible heights, many participants in this market found themselves on the verge of bankruptcy.

Derivatives appeared as an exchange instrument in the mid-19th century in the United States. These were futures and options for the supply of grain. By selling such contracts, farmers insured themselves against crop failure.

Derivatives began to be traded on the London Stock Exchange in the 1930s. The underlying assets were in most cases commodities, and in the 70s, futures for currencies and stocks appeared. Trading in swaps and over-the-counter derivatives began in the 1980s.

Concept and economic essence

Derivatives, also known as derivative financial instruments, are agreements (contracts, agreements) between two parties regarding the disposal of some asset in the future at a pre-agreed price.

The market on which such instruments are traded is called a forward market, because one of the mandatory parameters of the contract is the execution date.

The list of available derivatives can be found on the Moscow Exchange.

If we ignore financial markets, examples of derivative transactions from everyday life can be:

1. You are planning to buy a car, but it is not available in the showroom. Then you make an advance payment (a guarantee to the seller that the deal will not fall through), enter into an agreement to supply the brand of car you need from the factory at the price today, but in 3 months, for example.
2. You came to the store and saw a cool dress from the new collection. You don't have the required amount right now. You ask the seller to postpone the goods for 1 day. Tomorrow you buy the dress you want at yesterday's price.
3. You are selling an apartment. The paperwork process is slow. To protect yourself from the failure of the deal and the loss of the buyer, you ask the latter for an advance and guarantee him that the price will not change and the apartment will definitely be his.
4. Many examples can be cited from agriculture. This industry is seasonal. You never know what will happen with the weather, yield, competitors, etc. Farmers sow fields and look for buyers in advance at the current price in order to protect themselves from a possible drop in price. Large retail chains are also interested in concluding supply contracts in advance, fearing that costs may rise.

In economics, the concept of derivatives is most often associated with exchange and over-the-counter trading. The definition I gave above refers to the ability to dispose of some asset as a result of a transaction. Such an asset is called the underlying or primary. It consists of:

• securities (shares, bonds, bills, etc.);
• commodity instruments (gold and other metals, grain, coffee, oil, etc.);
• currency pairs (dollar/ruble, euro/dollar, etc.);
• stock indices (RTS index, Moscow Exchange index);
• interest rates (money market rate RUSFAR, overnight lending rate RUONIA);
• market volatility.

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Features of derivative transactions:

1. Urgency. The contract stipulates in advance the time for delivery of goods (delivery contract) or for making monetary payments (settlement contract).
2. Availability of an underlying asset.
3. A fixed price at which a futures contract will be executed in the future. At the same time, derivatives, like ordinary securities, are bought and sold on the exchange, and therefore have their own market price, which is different from the price of execution of the agreement.
4. High risk. Any futures contract is based on the assumption that the price of the underlying asset will change. The execution time is usually several months. Obviously, anything can happen during this time. No investor can predict the future.
5. Opportunity to earn more than with regular securities trading.
6. In some cases, a guarantee deposit is required. If one of the parties to the transaction refuses to fulfill the contract, it remains with the other party.

What are derivatives

So, a derivative (English derivative - derivative) is a contract containing the right or obligation to buy (sell) an underlying asset at a price agreed upon by the parties to the transaction at the time of execution of the derivative. A derivative instrument is a type of risk hedging for one or two parties.

Here is an example of a derivative in simple words. I intend to buy a new car, but the model I need in a certain color has not yet arrived from abroad. I make an advance payment and enter into an agreement with the seller (car dealership) that the car will be transferred to me no later than such and such a date. In turn, I undertake to pay for the purchase in full within the same period.

If while the car is on the way, the exchange rate rises, I will not worry, since the cost of the goods is fixed in the contract.

Thus, I am insured against currency risk, and the seller is insured against the risk of costs associated with the delivery of goods that will not be sold.

And on the stock exchange, derivatives are also traded - the buyer or seller can transfer the right or obligation to another person. The subject of the transaction can be goods, shares, currencies and even interest rates.

Features of derivatives

Derivatives were originally used to provide balanced exchange rates for goods traded internationally. International traders needed a system to account for differences in the value of national currencies.

Let's say a European investor has investment accounts denominated in euros (EUR). Let's say they buy shares of a US company on a US exchange for US dollars (USD). This means that they are now exposed to currency risk for as long as they own these shares. Exchange rate risk is the threat of an increase in the value of the euro relative to the US dollar. If this happens, any profit the investor makes when selling the shares will become less valuable when converted into euros.

A speculator expecting the euro to appreciate relative to the dollar can make a profit by using a derivative whose value rises with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor does not have to hold or have the underlying asset in a portfolio.

Many derivatives use leverage, meaning that a small amount of capital is required to have a stake in the large value of the underlying asset.

Why are derivatives needed?

So, the main function of derivative instruments is to hedge risks. The parties protect themselves from losses. For example, when purchasing a futures contract for the supply of oil, the buyer has the opportunity to “stake out” a favorable price for the future. He doesn’t need oil now, but there are fears that in six months, when reserves run out, the cost of raw materials will rise. Therefore, he purchases the derivative and calmly waits for the delivery date.

The second function is to make a profit on the difference in quotes. In other words, speculation. Derivatives trading for this purpose is practiced by experienced traders as it involves high risk. Speculation in derivatives emerged due to their popularity. Contracts can be resold in the same way as the underlying assets, and participants in the transaction receive income through the use of leverage.

Derivatives trading with Admirals

Now that you know what a derivative is, what the different types of derivatives are, and why and how different derivatives can be used, it may be time to make your first trade.

You can do it in just 3 steps:

1. Open an account to trade derivatives
2. for derivatives trading
3. Open the New Order window and place your first trade!

You can also watch a short video on how to open a derivatives trading account with Admirals:

Let's look at an example of how to buy and sell Dow Jones CFDs.

How to buy CFDs?

1. Login to your Admirals trading account (MT4/MT5/WebTrader/Mobile App)
2. Go to the Market Watch window
3. Find Dow Jones CFDs [DJI30]
4. Right click on the symbol and select "Graph Window"
5. Click on the “New Order” button (on the toolbar located under the menu).
6. Set the desired order volume, as well as stop loss and take profit levels if you want to place them.
7. Click on the blue "Buy" button.

When you buy (long) Dow Jones CFDs, you expect them to increase in value so that you can potentially profit from the trade.

How to sell CFDs?

1. Login to your Admirals trading account (MT4/MT5/WebTrader/Mobile App)
2. Go to the Market Watch window
3. Find Dow Jones CFDs [DJI30]
4. Right click on the symbol and select "Graph Window"
5. Click on the “New Order” button (on the toolbar located under the menu).
6. Set the desired order volume, as well as stop loss and take profit levels if you want to place them.
7. Click on the red “Sell” button.

When you sell (short) Dow Jones CFDs, you expect them to fall in price so that you can make a potential profit on the trade.

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Other derivative product options

It should be noted that there are other, less common types of derivatives. Let's look at what derivative instruments belong to them and their properties:

1. CFD (Contract for difference) – contracts for price difference. These derivatives are similar in nature to futures, but have two significant differences:

• do not provide for the delivery of the underlying asset;
• have no expiration date.

A CFD is a speculative instrument that follows the price of an underlying asset. For example, an oil CFD follows the Brent futures with a 3-month expiration date. This means that in August the CFD is equal to the futures price in November.

1. Forward (Forward Rate Agreement) – an agreement on a future interest rate. Strictly speaking, this derivative is a type of forward and has the characteristics of an interest rate swap, the example of which was discussed above. One party agrees to lend funds to the other party at a fixed interest rate. However, no real loans are issued. Both parties have their obligations to third parties, formalized in separate agreements. In simple terms, an FRA derivative insures participants against changes in interest rates by providing payment of the difference between the interest set by the terms of the contract and the market rate.
2. Warrants are derivatives with the characteristics of an option. Only the warrant is issued not by the exchange, but by the issuer of the shares. The price of the warrant is lower than the cost of the option, and the term is longer. As a rule, this instrument is used to reduce the risks associated with the circulation of new securities.
3. Structured products are complexes of financial instruments that combine protective and risk parts. For example, the protective part (90%) may consist of deposits and government bonds, and the risky part (10%) may consist of oil futures. In simple words, a structured product is a derivative that is a formed investment strategy or a ready-made portfolio compiled for a certain period.

Derivatives market

Modern derivatives markets can be described in one word – huge. For example, Visual Capitalist estimates them at 1 quadrillion dollars.

Here's a complete list from Visual Capitalist, summarizing every market in the world, from smallest to largest, and their valuation:

Source: Visual Capitalist

However, it is worth mentioning that due to their intangible nature, the value of financial derivatives is measured in two very different ways:

1. The contingent value represents a contractual obligation (i.e., an offer to buy 100 shares at $50 per share).
2. Gross market value measures the price of the derivative security itself (i.e., $1 per call option times 100 shares).

It's a pretty subtle difference that shows up mostly in the numbers. But let's take a closer look at what types of derivatives make up this giant market.

Features of derivative transactions

Let us briefly formulate the criteria for the economic essence of derivatives and their distinctive features:

• link to the underlying asset. A derivative cannot exist on its own; it is always dependent on some instrument;
• fix price;
• urgency;
• the presence of a guarantee that protects the seller of the derivative from non-fulfillment of obligations by the buyer;
• potentially high risk;
• expected high returns. Because derivatives are often used as a speculative instrument, professional traders make more money from them than from stocks and bonds.

Advantages and disadvantages

Advantages of derivatives:

• if in ordinary transactions on the stock market an investor earns only from rising asset prices and receiving dividends/coupons, then in derivative transactions this can also be done from a falling market;
• the entry threshold is significantly lower than in a regular transaction, due to the need to make only a guarantee obligation;
• The following advantage follows from the previous advantage: the opportunity to earn large sums with minimal capital and in a short time.

Flaws:

• the difficulty of predicting market movements, the unpredictability of natural, political, and social factors lead to the fact that derivative transactions are associated with great risk;
• Beginners need serious preparation to participate in this type of transaction; learning from their own mistakes can be too expensive;
• is not a tool for a long-term and passive investor; it requires time not only to study the theory, but also to monitor the market situation.

Possible risks can be reduced by diversifying the investment portfolio, i.e., including different asset classes and directing a small part of the capital to participate in futures transactions.

Risks of working with derivatives

The classification of risks associated with derivatives is similar to transactions with any assets.

1. Market risks. If the quotes of the underlying asset change in a direction unfavorable for the participant in the transaction, the seller or buyer of the derivative receives a loss. But it is precisely this risk that allows you to get high returns with a successful trend. Interestingly, derivatives are often used as a tool to hedge these same market risks. Thus, when used correctly, derivatives that perform a hedging function involve less risk than derivatives used for speculation.
2. Credit risks. They are associated with the use of leverage and failure to fulfill obligations of one of the parties to the transaction. For example, an option seller who receives a guarantee fee is exempt from credit risk. A buyer who acquires the right, rather than the obligation, to complete a transaction also does not have this risk. But if the asset is acquired using borrowed funds, the situation changes. In this case, if the buyer refuses to complete the transaction, the seller suffers a loss.
3. Liquidity risks. When the market liquidity of the underlying asset decreases, the demand for derivative instruments correspondingly decreases.
4. Operational risks are associated with differences in settlement times, costs of exchange transactions, failures in automated systems and errors caused by human factors.
5. Legal risks are associated with incorrect execution of documents, the likelihood of bankruptcy of one of the parties, and other force majeure circumstances.

Derivatives trading and live trading

Derivatives trading mimics real-life trading of financial instruments, except that in derivatives you don't actually own the underlying asset, unlike, for example, real shares of a company. What we call derivatives trading in financial markets is certainly an excellent alternative to the well-known trading of real assets (stocks, bonds, etc.).

Of course, there are some key differences between buying real stocks and trading derivatives:

✔️ You can trade both long and short derivatives positions, and you are not required to provide the underlying asset when going short. ✔️ Derivatives are not subject to 0.5% tax in the UK, although profits are subject to income tax ✔️ The investor does not own the underlying asset underlying the contract for difference, but instead contracts with a derivatives broker to exchange the difference between the starting and ending prices of the contract . ✔️ Unlike owning the underlying asset, derivatives can be traded using leverage, i.e. an initial deposit (even a small one) gives the investor the opportunity to manage a large volume of asset positions.

One of the most attractive features of derivatives trading is the use of leverage, which is another way to trade on margin.

For example, using a leverage of 1:30, a trader can open a position of 30 times his underlying capital.

Of course, trading derivatives also has its disadvantages:

1. You do not own actual shares, which deprives you of some ownership rights upon liquidation of shares and the right to vote at the general meeting of shareholders.
2. Trading derivatives today is much less strictly regulated than trading real stocks. Because of this, derivatives attract many unregulated brokers, poorly regulated brokers, and even fraudulent brokers.

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Where and how to buy derivatives

For the average investor, derivatives are available on the derivatives desks of stock exchanges. Derivative financial instruments can be purchased on trading platforms:

Site name	Types of underlying assets
Moscow Exchange	• OFZ; • stock; • currency; • interest rates
St. Petersburg Stock Exchange	• goods
Chicago Mercantile Exchange	• goods; • cryptocurrency

Step-by-step algorithm of the trading process:

1. Choosing a broker and opening an account:

• familiarization with broker ratings;
• choosing a broker;
• opening an account on the website;
• creating a personal account;
• ID confirmation;
• installation of a trading terminal;
• refill.

1. Selection of trading instruments:

• selecting a category (commodities, securities, currency, etc.);
• choice of derivative (futures, options, swaps, etc.).

1. Fundamental and technical market analysis:

• historical data on the value of the underlying asset and derivative instrument;
• forecasting;
• analysis of factors influencing price changes.

1. Purchasing a contract:

• determination of contract parameters (volume, terms, price);
• drawing up specifications;
• filling out a purchase application;
• completing a transaction.

Recommendations for novice investors:

1. Before you start trading derivatives, get trained with various strategies in the demo version.
2. Choose the most liquid assets: shares of large companies, oil futures, indices.

Derivative financial instruments: futures, options - what is the difference

I. What are derivative financial instruments and the derivatives market

An exchange is a platform on which trading of various assets is carried out in an organized manner.
There are basic and derivative types of assets. The underlying asset can be: stocks, bonds, commodities, stock indices, currencies and interest rates.

Derivative financial instruments (derivatives) are a contract under which the parties receive the right or undertake to perform specified actions in relation to the underlying asset. Actions include: the ability to buy, sell, provide, receive goods or securities.

Derivative financial instruments are traded on the derivatives market.

II. Why does an investor need derivatives?

Try to reduce market risks arising from transactions with underlying assets - that is, use a hedging strategy in which you can make a transaction on pre-agreed conditions.

The derivatives market provides ample opportunities for implementing various trading strategies, including speculative ones. There are additional opportunities here: to complete a transaction, you do not need to pay the full cost of the contract, providing only the amount of the guarantee security (GS). For example, it could be about 10–20% of the transaction amount. The size of the GO is set by the exchange.

By blocking only the GO, the so-called leverage effect appears - compared to buying the underlying asset, you can buy more derivatives for the same amount. Both risks and profitability increase proportionally.

Important: speculative aggressive strategies entail increased risks. It is worth carefully assessing the proportion of capital that an investor is willing to risk. An important condition, especially for a novice investor, is the ability to correlate risks and manage them as part of your portfolio strategy. It is necessary to ensure that there are sufficient funds for the GO so that the broker does not forcefully close the position.

With the help of derivatives market instruments, you can not only speculate or hedge your obligations (for example, a foreign currency loan), you can also use an arbitrage strategy. Arbitrage is several logically related transactions in order to profit from differences in prices for identical (or related) assets: at the same time in different markets (spatial arbitrage) or in the same market at different points in time (temporal arbitrage ).

III. Popular derivatives

A futures is an agreement (contract) between a seller and a buyer to deliver an underlying asset after a specified period of time and at a predetermined price. The main thing: a futures implies obligations for both parties: the seller is obliged to sell, and the buyer is obliged to buy the selected asset on the agreed terms.

An option is an agreement under which the buyer of the option receives the right to buy/sell an asset (commodity, security, currency, etc.) at a certain point in time at a predetermined price. The main thing: this is the obligation of one side and the right of the other.

One of the organizers of trading on the derivatives market is the Moscow Exchange. The exchange acts as a guarantor of fulfillment of obligations. Clearing is carried out by JSC National Clearing Center.

IV. Who is suitable for derivative financial instruments?

Derivatives provide investors with many options:

- trade “the entire market” using futures on the Moscow Exchange or RTS index - indirectly invest in goods, the purchase and storage of which is associated with high costs (gold, oil, wheat, etc.) - play out world news - play out the formation of prices for goods — implement arbitrage strategies with global commodity and stock markets — hedge investments in stocks — hedge currency risks, etc.

V. How futures work

Key Features of Futures

The subject of a futures contract (what is being bought/sold) is called the underlying asset. By underlying asset there are: - futures of the Moscow Exchange stock section: for stocks, baskets of bonds, indices, investment shares; — futures of the money section of the Moscow Exchange: for currency pairs, for interest rates; — futures of the Moscow Exchange commodity section: for Brent and Light Sweet Crude Oil, natural gas, gold, silver, copper, platinum, palladium, etc.

Statistics from the Moscow Exchange show that more than 50% of the volume consists of trading in futures on underlying currency assets; the rest of the volume is accounted for by commodity and index stocks—approximately equally divided.

Futures contracts have predetermined expiration dates. The moment the futures contract is executed is called expiration. Monthly and quarterly contracts are traded on the Moscow Exchange Derivatives Market. The transaction imposes an obligation on the participants to fulfill the terms of the contract on the day the futures expire (expiration). The basic conditions for trading a futures contract are standardized by the exchange and set forth in the Futures Specification. The document includes the main characteristics: contract execution date; the amount of the underlying asset that is delivered upon execution of the deliverable futures contract; the amount of the exchange commission for buying/selling or when executing a futures contract; methods of mutual settlements; futures price currency, etc.

The parties are obligated to the exchange until the futures are executed or positions are closed.

You can find out the current futures quotes, the execution date, and the amount of collateral in the Specifications and in the Instrument Parameters on the official website of the Moscow Exchange.

Futures classification

According to the type of execution, futures are either delivery or settlement.

Deliverable futures - on the contract execution date, the buyer must purchase and the seller must sell the quantity of the underlying asset established in the specification. Delivery is carried out after expiration at the settlement price fixed on the last date of trading. If you close a futures position before expiration, delivery of the underlying asset will not occur.

Settlement (non-deliverable) futures - only monetary settlements are made between participants in the amount of the difference between the contract price and the settlement price of the contract on the execution date without physical delivery of the underlying asset. That is, the investor either receives a profit or writes off a loss.

Futures life cycle

Several futures for one asset can be traded at the same time - the nearest ones and those with a longer expiration date. For the most liquid futures there may be 8 contracts with quarterly expirations. Brent oil is traded in 12 monthly contracts.

As a rule, the further away the expiration date, the less liquid the instrument.

VI. How options work

The key features of options are similar to futures. Therefore, to understand, let’s figure out what the main difference between an option and a futures is.

This is the unevenness of the obligations of the parties to the transaction. For the option seller, everything is identical to the transaction in futures: this is an obligation to make a transaction with the underlying asset in the future at a given price and under given conditions. But for the buyer, this is the right (not the obligation) to buy or sell, under certain conditions, a certain amount of the underlying asset within the period established in the conditions. That is, the buyer can either agree or refuse this right.

To balance the positions of the parties, an option has an additional characteristic that a futures does not have - this is the option price, or option premium. It is paid to the seller and remains with him, regardless of whether the contract is executed.

The option premium is divided into two subtypes: Call option - the right to buy for the buyer and the obligation to sell for the seller Put option - the right to sell for the buyer of the option and the obligation to buy for the seller.

These options are traded differently. The point is that they have different premiums, or rather, their size and market value.

Basic parameters of options

The premium, or cost, of an option is the market price at which the transaction takes place. Strike, or exercise price, is the price at which rights and obligations under an option can be exercised. The expiration date, or maturity date, is the period before the contract expires. The contract volume is measured in units of the underlying asset.

The option premium is determined as a result of exchange trading. It is formed from two main parts:

Intrinsic value occurs when the price of the underlying asset of the option exceeds the strike price (in case of growth), and represents the difference between these two values. Time value is the expectation that the value of an underlying asset will change in the future. It depends on the volatility of the underlying asset and the option exercise date.

Options are a more flexible instrument than futures and stocks. They enable traders to reflect absolutely any view of the market: growth, decline, limited growth or decline, stagnation, increased volatility (fluctuations) of prices in the market without a significant final change in price, other options for market behavior.

So, the seller is obliged to fulfill the terms of the transaction. And it is important for the buyer to “want” to implement it. Let's consider cases in which this will be beneficial to the buyer.

Depending on the ratio of the price of the underlying asset and the strike price, three types of options are distinguished:

— Option “in the money” = the exchange executes them automatically for a Call option: when the current price of the underlying asset is greater than the option exercise price (strike); for a Put option: when the current price of the underlying asset is less than the option's strike price (strike).

— Option “at the money”: when the current price of the underlying asset is equal to the option exercise price (strike) = the exchange automatically exercises it in half.

— Option “out of the money” = the exchange executes them only at the order of the buyer. for a Call option: when the current price of the underlying asset is less than the option exercise price (strike); for a Put option: when the current price of the underlying asset is greater than the option's strike price (strike).

When purchasing options, the loss in this situation will be limited by the size of the premium - this is precisely what was the subject of bargaining and the strategy when concluding the option, increasing the predictability of investments. That is, the financial result of the seller is limited profit with potentially unlimited loss (!).

Options are available monthly and quarterly.

What are options for?

When purchasing an option, both parties assess the amount of risk of an unfavorable change in the price of the underlying asset, which is included in the premium.

Buyers typically use an option to hedge (reduce) risk or make a profit. Sellers pursue the goal of making money from its sale. To do this, they set (or calculate using a certain formula) a fair option premium.

Differences between an option and a direct purchase (sale) of an asset: - limited risks for the buyer (no more than the option price); — established terms for mutual settlements; — lower costs of transactions in the derivatives market.

BCS World of Investments

Comparative characteristics of derivatives

Let's conduct a comparative analysis by types of derivatives:

Name of derivative	Where is it traded?	Liquidity	Volatility	Risk
Futures contract	Stock exchanges	High	Depends on the underlying asset	High
Forward contract	OTC market	Average		Average
Option	Stock exchanges	High		Average
Swap		Average	Average
CFD			High	High

This characteristic is very conditional, since the volatility, risk, and profitability of a derivative depend, firstly, on the underlying asset, and secondly, on the investor’s goal. If a derivative is a hedging instrument, then all parameters are averaged. And if a derivative instrument is used to make money on the difference in quotes, both risk and profitability increase accordingly.

As for liquidity, almost all derivatives are liquid because they are used in the short term and are purchased for a specific purpose - either to make money on price fluctuations or to balance the risk.

What is a derivative in simple words

A derivative (derivative financial instrument or derivative) is a security whose value depends on or is a derivative of an underlying asset or group of assets. A financial derivative itself is a contract between two or more parties, and its price is determined by fluctuations in the value of the underlying asset.

The most common underlying assets of derivatives are:

• Currencies
• Stock
• Bonds
• Stock indices
• Commodities

Derivatives are typically purchased through financial intermediaries such as Admirals (formerly Admiral Markets).

The oldest derivatives transaction was described by Aristotle. He testified to an olive transaction in which the ancient Greek philosopher Thales participated.

According to history, the Greek philosopher Thales predicted that next year's olive harvest would be very good. Since no one could know for sure whether his words would turn out to be true or not, Thales managed to negotiate with the owners of the olive presses for the right (but not the obligation) to hire all the olive presses in the region the following autumn for a small sum, which he paid as a deposit.

The harvest was indeed rich and the demand for olive presses was high, and Thales was able to charge a high price for renting the presses, making a fortune.

Why can this be considered an example of financial derivatives? It's simple: Thales did not actually purchase the underlying asset (the olive presses), but instead paid collateral to secure his rights to use them through a contract. All he bought was a contract (derivative). If the harvest was bad, his losses would be limited to the deposit he paid.

Learn more about derivatives trading in the financial markets with a free training course from Admirals. Get access to the course completely free by clicking on the banner below!

Pros and cons of derivatives

Having analyzed the classification of financial instruments related to derivatives, we list their advantages and disadvantages.

Among the advantages it is necessary to highlight:

• risk hedging;
• cost reduction. We looked at the example of a swap about lowering interest rates. In addition, derivatives allow you to save on brokerage commissions, since these payments depend on the transaction amount, and a derivative is always cheaper than the underlying asset;
• fixed amount;
• high profitability.

Disadvantages of derivatives:

• risks of non-fulfillment of obligations;
• lack of legislative regulation (this paragraph applies to over-the-counter instruments);
• If used incorrectly, leveraged derivatives can cause significant losses.

Exchange-traded and over-the-counter (OTC) derivatives

Derivatives can be traded over the counter (OTC) or on an exchange. Over-the-counter derivatives make up the majority of the derivatives market.

OTC derivatives generally have a greater likelihood of counterparty risk. Counterparty risk is the risk that one of the parties involved in a transaction may fail to fulfill the contract. These two parties trade privately with each other and it is not regulated.

Conversely, derivatives that are traded on an exchange are standardized and more heavily regulated.

Examples

I'll give you a couple more examples of derivatives transactions in simple terms.

Example 1. Here we will look at an exchange instrument - an option. The trader bought a put option on August 10 with a premium of 500 rubles, giving the right to sell 1000 shares of Microsoft at a price of 295 rubles. The price of one share at the time of purchasing the option was 285 rubles. The option exercise date is September 24. On this date, the shares cost 289 rubles, and the trader decided to exercise the option and sell the securities at 295 rubles, and 500 rubles. – these are the costs for obtaining this right. Profit amounted to:

295*1000-289*1000-500=5500 rub.

Example 2. Here we will look at an over-the-counter instrument - a forward contract.

The importing company entered into a contract with a foreign counterparty for the supply of goods worth RUB 37,500,000. ($500,000 or 14,500,000 UAH). The current exchange rate of the American currency is 72.5 rubles. Payment is due in 2 months. At the current exchange rate, the amount to be paid will be 36 million 250 thousand rubles. (500000*72.5).

If in two months the dollar grows, say, to 76 rubles, then the contract amount in ruble equivalent will already be 38 million rubles. (500000*76). In this case, the forward contract will allow you to fix the current rate. The Russian company will use the broker's leverage of 1:20 and make an advance payment of 20% (RUB 7,500,000 ($100,000 or UAH 2,900,000)) at the current rate (72.5). Thus, the buyer receives a guarantee of purchasing the goods at a fixed exchange rate of American currency.

The essence of a derivative as a financial instrument

To understand what derivatives are and why they are needed, first of all, you need to understand that they are simple words, derivative financial instruments. That is, there is an asset that is considered underlying. According to it, a bilateral agreement is concluded, the participants of which undertake to complete the transaction on pre-established conditions.

Despite the complexity of the wording, such agreements are often found in our everyday life. By the way, the simplest example is purchasing a car at a car dealership according to the “made to order” scheme. In this case, the buyer enters into an agreement with the dealership for the supply of a car of a specific model, in a specific configuration and at a specific fixed price.

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Such an agreement is a simple derivative in which the asset is the ordered car. Thanks to the concluded contract, the buyer is protected from changes in value, which may increase by the agreed date of purchase. The seller also receives certain guarantees - a rare car, which he purchases from the manufacturer, will definitely be purchased and will not “hang” in his salon as “dead weight”.

The modern derivatives system began to take shape in the 30s of the 19th century. Financial derivatives are a product of the 20th century. The starting point is considered to be 1972, when the international currency market that we know today finally took shape.

If previously only real goods were used in such transactions, then with the advent and development of financial derivatives, it became possible to conclude contracts in relation to currencies, securities and other financial instruments, up to the debt obligations of individual companies and entire states.

Chicago Board of Trade, 1993

The Russian derivatives market was formed in the 90s of the last century. Despite the fact that this segment is actively developing, it is characterized by the problems of all young markets. The main feature is the lack of competent personnel, especially among ordinary market players. Not all participants know for sure what derivatives are and their properties. All this leaves an imprint on the development of the market.

How to make money on derivatives?

There are many ways to make money in the derivatives market. Private investors most often use options and futures for speculation as they are the most understandable and common instruments.

Earnings depend on the chosen strategy. You can speculate on the derivative itself, reselling options and futures on both the security and the value of the asset. For example, buy an option to buy shares at a price lower than the market price, wait until it is exercised, receive the shares and sell them at a higher price.

It is easier to show exactly how to make money on derivatives using the example of an option.

For example , one share of Sberbank costs 250 rubles. A certain trader predicts that in the near future the price should increase by 50% to 375 rubles. He buys a call option with a margin of 10%, i.e. for 25 rubles. Now, when the price of Sberbank shares rises to 375 rubles, the trader will be able to exercise the option and buy Sberbank shares worth 375 rubles for 250 rubles. By selling shares at the market price, he will earn (375 – 250 – 25) = 100 rubles. With 250 rubles, you can buy 10 options on the same conditions - as a result, your earnings will be 1000 rubles. If a trader had simply bought 250 rubles worth of Sberbank shares and sold them for 375 rubles, he would have earned only 125 rubles.

Thanks to the built-in leverage, you can earn much more on derivatives than on the underlying assets.

Currency hedging using derivatives

In addition, hedging using derivatives is often used to protect funds from unwanted movements in exchange rates. For hedging itself, transactions in foreign exchange markets are used. For example, on the Moscow Exchange there is also a currency section where you can make relevant transactions. A striking example of such markets is FOREX.

Transactions in these markets can be made using so-called leverage. Margin positions help significantly when there are insufficient funds in this market. But this is also another risk for the investor, increasing possible losses. The meaning of hedging is to buy/sell currency contracts for a period, simultaneously with the sale/purchase of the currency that you have in stock, with the same delivery period, plus conducting a reverse transaction when the actual delivery date of the currency arrives.

Hedge when investing

Returning to derivatives, in terms of investments. It is acceptable to say that they can be used to hedge positions or the entire portfolio. For example, a portfolio of high-quality stocks has been assembled. Growth is expected throughout the year, but many local spills may occur during this period, whether due to negative news, sanctions or other reasons. So, it is precisely in moments of volatility that we can hedge our positions by shorting the RTS index, the Moscow Exchange, or by buying PUT options on the corresponding instrument.

Futures contracts are easier to work with because they are the same asset, only measured in contracts. Working with options requires preparation. It should be taken into account that futures and options have a strict trading time frame. Let's take the current gold futures GDM9 as an example. The beginning of his appeal is 06/08/2018. Expiration, that is, the execution date is 06/20/2019. It turns out that this contract is traded for only one year, provided that liquidity appears in it 2-3 months before the end of the term. For a speculator, this time is quite enough. Many people trade intraday without even moving their position overnight.

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Example

Let's look more specifically at another example with the amount of 1,000,000 rubles. We buy 130 shares of Lukoil at a price of 5,760 rubles. Total cost 748,800 rubles. The outlook for the company is positive, but a local drawdown is expected. Futures on Lukoil shares will help us minimize risk. The LKM9 futures is currently trading with an expiration date of June 21, 2019. If fears are confirmed and the stock experiences a certain drawdown, the futures will compensate for the losses with profits on its short. So, to hedge, we need to sell 240 contracts at a price of 58131.

If the shares drop to 5,000 rubles (a loss of 98,800 rubles), shorts on the futures will bring an equivalent profit. But keep in mind that in order to carry out transactions with futures, the account must also have funds for collateral, otherwise the transaction will not be completed.

Impact of derivatives on the 2008 economic crisis

The crisis of the American mortgage bond market in 2007 led to the beginning of a financial and economic crisis throughout the world. Most analysts and economists associate the crisis with the excessive development of the derivatives market and their key role in the collapse of the global economy.

The US housing bubble had the following reasons:

• The rise in prices for houses and apartments, significantly faster than inflation, led to the creation of artificial demand. There was a real “housing boom”.
• The boom was financed by cheap money (low mortgage rates), second mortgages (a second loan on a home you already own), and loans with no or 5% down payment.
• A self-accelerating mechanism for the growth of housing sales and prices began, which led to the inflation of a soap bubble in the real estate market.

But with all this, American banks would not have allowed such a sharp increase in mortgage loans if a new “securitization” mechanism had not been formed (removing the risks of non-repayment and financing these loans). The essence of this term is to turn almost anything into a security.

Structured mortgage securities became widespread and were purchased by banks, various funds and institutional investors.

The mortgage-backed securities market is just a small part of the derivatives market. The volume of turnover of the over-the-counter share of such a market is difficult to estimate and statistics, but in the summer of 2008 it reached more than $600 trillion, which is comparable to ten times global GDP.

As a result of speculative actions and the lack of competent regulation on the part of the state, the bubble burst at one point, which led to economic collapse and a series of major bankruptcies.

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