Trading Derivatives: Overview, Strategies and Markets

A derivative is a financial instrument whose value is derived from the price of another asset or market, known as the underlying.

The underlying could include:

• Stocks
• Indices
• Currencies
• Commodities
• Interest rates
• Bonds

Rather than buying or selling the underlying asset itself, a trader takes a position based on how they expect its price to move. This means derivatives can provide exposure to both rising and falling markets. A trader who expects an asset to increase in value could take a long position, while one expecting it to fall could take a short position.

There are several reasons traders use derivatives:

• Market access: Derivatives can provide exposure to multiple asset classes through a single trading account.
• Long and short opportunities: Traders can potentially speculate on both rising and falling prices.
• Leverage: Derivatives can allow traders to control a larger position with a smaller initial outlay. However, leverage also magnifies losses.
• Hedging: Derivatives can be used to offset potential losses elsewhere in a portfolio.
• Flexibility: Different derivative products can suit different approaches, from short-term speculation to longer-term hedging.

There are several types of derivatives, each with different characteristics. For retail traders, CFD trading and spread betting are particularly relevant.

CFDs

A Contract for Difference (CFD) is an agreement to exchange the difference in an asset's price between when a position is opened and when it’s closed. With CFD trading, you don't own the underlying asset; instead, you speculate on its price movement.

For example, if a trader believes an index will rise, they could open a long CFD position. If the index rises, the position could generate a profit. If it falls, the trader will make a loss. CFDs can provide access to markets including shares, indices, forex and commodities.

Advantages include:

• Access to a wide range of markets
• The ability to take long or short positions
• Leverage allows you to use less capital to control a larger position
• No requirement to own the underlying asset

Risks include:

• Leverage can magnify losses
• Short term - positions held overnight may incur financing costs
• You don't own the underlying asset
• Volatile markets can result in rapid losses

For more information, see ‘What Is CFD Trading?’, and our guide to CFD pros and cons.

Spread betting

Spread betting is another form of derivative trading. Instead of buying an asset, you speculate on whether its price will rise or fall. Your profit or loss depends on the size of your stake and the market's movement.

For example, suppose a market is quoted at 7,500-7,501 and you believe it will rise. You could place a buy bet at 7,501 with a stake of £10 per point.

If the market rises to 7,551, your gross profit would be: 50 points × £10 = £500

If it fell by 50 points, the gross loss would be £500, before applicable costs.

Spread betting provides access to multiple markets and the ability to speculate on rising and falling prices. However, leverage magnifies both gains and losses, and losses can exceed the initial amount deposited. Potential tax treatment can also differ from other forms of trading for UK residents, depending on individual circumstances and current tax rules.

See our guide to spread betting vs CFD trading for a closer comparison.

Other major derivative products include:

• Futures

Contracts to buy or sell an asset at a predetermined price on a specified future date.

• Options

Contracts giving the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price.

• Swaps

Contracts where two parties exchange financial cash flows according to agreed terms, often involving interest rates or currencies.

One of the main attractions of derivatives is the range of markets they can provide access to.

Forex

The foreign exchange market is one of the world's largest financial markets. Traders speculate on the relative value of currency pairs such as GBP/USD and EUR/USD.

Forex trading can be approached using a range of strategies, from short-term technical trading to longer-term fundamental analysis. See our breakdown of the top forex trading strategies for more information.

Shares

Derivatives can provide exposure to individual companies without requiring the trader to own the shares themselves. This can make it possible to speculate on both upward and downward price movements.

Stock indices

Indices such as the FTSE 100, S&P 500 and Nasdaq 100 allow traders to speculate on the performance of a basket of companies rather than a single stock.

Commodities

Derivatives are widely used to trade commodities including gold, silver, oil and natural gas. For example, traders may speculate on changes in oil prices without taking physical ownership of barrels of crude oil.

See our guide to commodities trading for more information.

Interest rates and bonds

Interest-rate derivatives can be used to speculate on or hedge against changes in borrowing costs, while bond derivatives provide exposure to movements in fixed-income markets.

There isn't one universal approach to trading derivatives. Strategies depend on the market, timeframe and objectives of the trader.

Trend following

Trend-following strategies attempt to identify an established market direction and trade in line with it. Moving averages and other technical indicators can help identify trends.

Breakout trading

A breakout occurs when price moves beyond an established support or resistance level. Traders may look for increased momentum or other signals to confirm a breakout before entering a position.

Range trading

Range traders look for markets moving between established support and resistance levels. They may look to buy towards the lower end of a range and sell towards the upper end, although a breakout can invalidate the strategy.

Hedging

Derivatives can also be used to offset risk elsewhere. For example, an investor with a portfolio of shares could potentially use a short index position to offset some of the risk associated with a broader market decline. Hedging doesn't eliminate risk and may introduce additional costs.

Leverage is one of the defining characteristics of many derivatives. Rather than depositing the full value of a position, a trader provides a percentage of its value as margin.

For example, if a position has a notional value of £10,000 and requires 10% margin, the initial margin would be £1,000.

However, profit or loss is based on the full £10,000 exposure. A 5% move in the underlying market would therefore represent £500, equivalent to 50% of the initial £1,000 margin in this simplified example. This is why leverage needs to be treated carefully.

Good risk management can include:

• Position sizing: Consider total exposure rather than simply the margin required.
• Stop-loss orders: These can help limit losses, although execution isn't guaranteed at the requested price during fast-moving markets.
• Margin monitoring: If a leveraged position moves against you, available margin can fall and positions may be closed if requirements aren't maintained.
• Understanding costs: Spreads, commissions and overnight financing can all affect returns.

The main benefits include:

• Access to a broad range of markets
• The ability to trade both rising and falling markets
• Leverage
• Opportunities to hedge existing exposure
• Flexibility across different trading strategies

The main risks include:

• Leverage magnifying losses as well as gains
• Potential losses exceeding the initial deposit
• Financing and transaction costs reducing returns
• Rapid market movements causing significant losses

Understanding both sides is essential before deciding whether derivatives are appropriate for you.

Trading derivatives provides access to a broad range of financial markets without requiring direct ownership of the underlying assets. CFDs and spread betting, in particular, allow retail traders to speculate on rising and falling markets across assets such as shares, indices, forex and commodities.

However, greater flexibility comes with greater responsibility. Leverage can provide efficient market exposure, but it can also magnify losses and means you can lose more than your initial deposit.

Whether you're exploring derivatives markets, developing a trading strategy or considering CFDs or spread betting, sign up with Trade Nation or switch to us today.