TYPES OF DERIVATIVES AND HOW TO TRADE THEM

Investors use derivative to participate in the price action of the underlying security and to transfer risks associated with the underlying asset to another party. Here are the 4 most used derivatives in the markets today and how to trade them.

Options

Investors use options to hedge risks and/or to speculate by willingly taking on additional risks. When they buy a call or a put option, they acquire the rights minus the obligations to buy (call options) or sell (put options) the shares or futures contracts at a predetermined price before or at an expiration date.

Options can be traded and centrally cleared on exchanges, offering both transparency and liquidity, which are two extremely important factors when trying to profit from derivatives.

The primary factors that determine the value of an option include the time premium that decays as the contract nears the expiration date, the intrinsic value that varies with the price of the underlying asset, and the volatility of the stock or the contract.

Warrants

When you buy a stock warrant, you obtain the right to buy a stock at a specific price at a specific date. Just like call options, you can exercise this type of contract at a fixed price. 

Upon issuance, the price of the stock warrant is always higher than underlying stock’s price. However, it carries a long-term exercise period before it finally expires. When you exercise a stock warrant, the company issues new common shares to cover the transaction, not quite like call options in which the call writer must offer the shares if the buyer exercises the option.

Stock warrants usually trade on an exchange. However, there is liquidity risk since the volume can be low. An additional risk to consider is that the stock warrant has a time premium that decays as it nears expiration, just like call options.

Single Stock Futures

A single stock future (SSF) is a derivative contract that delivers 100 shares of an assigned stock on a predetermined expiration date. The market price comes from the price of the underlying security plus the carrying cost of interest, minus the dividends paid over the term of the contract.

Investors gain more leverage by trading SSFs because it requires lower margin than actually buying or selling the underlying security, usually ranging 20 percent. Additionally, SSFs are not subject to the Securities and Exchange Commission’s (SEC) day trading restrictions or to uptick rule that applies to short sellers.

SSFs are considered to be a cheaper method to buy a stock and cost-effective way of hedging for open equity positions. They are also used as protection for a long equity position against volatility or short-term declines in the price of the underlying asset.

Contracts for Differences (CFDs)

A CFD is simply an agreement between two counterparties (a buyer and a seller) that requires the seller to pay the buyer the difference between the current stock price and the value at the time of the contract if that value increases. On the flip side, the buyer has to pay the seller if the difference or the spread in the prices is negative.

The purpose of this derivative is to let investors speculate on the price movement without having to actually own the underlying shares.