Candlestick Trading Blog
March 9, 2010
Derivative Contracts
| Derivative contracts are agreements by which a trader gains leverage on investments in underlying financial instruments such as stock shares. Derivative contracts derive their value from the underlying instrument. However, they offer the opportunity for greater profit, the option to buy stock or sell stock at a given price, the possibility of hedging risk, and the possibility of trading where there is no underlying financial instrument. Derivatives contracts include those used in trading options, futures, commodities, foreign exchange trading, interest rates, or credits. Derivative contracts can be complex (exotic) or they can be simple (vanilla). The underlying features that all have in common is the ability to gain more profit and to have more choices at a future date. The risk with these contracts varies. For example, buying calls in options trading gives the buyer the option to buy 100 shares of stock per contract on or before a given date, the contract expiration date. Traders will pay a premium for this opportunity and will exercise options contracts, the derivatives, if the stock price goes up enough to make a profit. On the other hand selling calls gains the trader a premium but gives away the opportunity for substantial profits if the stock price goes up dramatically. The risk involved in derivative contracts varies. In fact, many trade derivatives as part of a hedging strategy while others engage in options trading and futures trading with potentially unlimited risk. An example of trading derivatives to reduce investment or business risk is a gold mining company selling futures on gold at a price below the current market value. The company guarantees themselves a profit on part of their expected production. This trading strategy can be used by investors in the company as well. Those engaged in long term investing can also take advantage of derivative contracts. A common tactic is the use of covered call options. An investor who is familiar with the support and resistance zones of one of his cyclical stocks can profit by selling covered calls when the stock is at the top of its traditional trading range. The investor gains the premium, offsetting his portfolio loss, while the stock cycles down in price. Another covered option is buying puts on a stock that has recently run up in price. The stock owner pays a little insurance in the form of the premium. If the stock corrects substantially he or she will then exercise the put options, sell at the strike price, and buy again at the new, lower, spot price. Managing risk in trading derivative contracts is important. Selling uncovered call options or uncovered put options opens the trader to potentially huge risk if the underlying financial instrument goes up dramatically in price. This sort of trading in derivatives is statistically very profitable. That is why large institutional traders do it. The problem for the individual investor or trader is that every so often the trade goes bad and there is a price to pay. Large institutions can handle the cost. Most individual investors cannot and should typically avoid trading where the potential for loss is great. Online Stock Market Reviews presented live via the internet by Stephen Bigalow |
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