Are you a trader looking for a fast-paced, lucrative derivative trading strategy? Futures trading is an effective way of speculating on the price movements in various markets without purchasing or owning any underlying assets. With futures trading, traders can harness the financial leverage provided by contracts that can be held securely and transferred quickly at a minimal cost.
In this comprehensive guide to derivatives and futures trading, we’ll explore how to use futures contracts as part of your trading plans and strategies with examples of actual trades. We will also discuss potential risks associated with futures contract play and binding terms every trader should understand before considering this form of trading.
What is Derivative Trading, and why is it essential for investors to understand
Derivative trading is a complex financial instrument that allows investors to speculate on the volatility and underlying value of assets such as stocks, currencies, and commodities. It involves buying or selling contracts derived from an underlying asset’s value.
Understanding how derivative trading works is crucial for investors, as it can help them manage risk, hedge against potential losses, and potentially earn some returns. However, it is essential to note that derivative trading can also be high-risk, and investors must be educated to avoid significant financial losses. Overall, derivative trading is a critical aspect of the modern financial environment, and understanding investors need to thrive in today’s dynamic world of finance.
Key Terms and Concepts Related to Futures Trading
Futures trading is a type of derivative that involves the exchange of contracts for the delivery or sale of a specific asset on a future date. Futures can be used as an effective tool in hedging against price risk, and they are often used to speculate on potential price movements.
When it comes to understanding futures trading, there are several key concepts and terms you should familiarise yourself with before placing any trades. These include but are not limited to margin requirements, leverage, liquidity, expiration dates, open interest, and basis points. Knowing these key terms will help you better understand how futures trading works and make informed decisions when evaluating potential trades.
Different Types of Derivatives and Their Role in Risk Management
Derivatives are classified into two broad categories: exchange-traded and over-the-counter (OTC) derivatives. Exchange-traded derivatives are standardised contracts bought or sold on an organised exchange. The most common type of this is the futures contract, which we’ll discuss in more detail later.
Over-the-counter derivatives, on the other hand, are customised contracts between two parties that do not trade publicly on exchanges. These can include options, swaps, forward contracts, and credit default swaps.
Regardless of which type of derivative you use, they both serve a significant role in risk management for investors. By using derivatives to hedge against potential losses due to market volatility or currency fluctuations, investors can transfer the risk associated with certain investments to another party while still having exposure to potential returns. It can be a great way to optimise and diversify your portfolio without taking too much risk.
Strategies to Consider When Making a Derivatives Trade
Now that you have a better understanding of derivatives and their role in risk management, we can move on to different strategies you can use when trading futures. One of the most popular strategies traders use is “spread trading”. Spread trading involves simultaneously buying one contract at a higher price and selling another at a lower price. This strategy allows investors to benefit from market movements without taking on large amounts of risk.
Another popular strategy is “momentum investing”, which takes advantage of short-term trends in the market by entering and exiting trades in rapid succession to capture potential profit opportunities. This form of trading requires careful timing and quick decisions as it carries high volatility risk.
Finally, “contrarian investing” is a strategy that takes the opposite approach of momentum investing by buying underperforming assets while selling those outperforming to benefit from market corrections. This type of trading can be highly lucrative but carries high-risk levels and requires investors to thoroughly know the markets.
How to Calculate the Potential Return or Loss of a Future Trade
When trading futures, it is vital to understand how to calculate each trade’s potential profit or loss. The most common method to calculate potential return or loss for futures trading involves multiplying the number of contracts by the difference between the entry and exit price and subtracting any applicable fees, such as commissions.
For example, if a trader enters into a long position with five contracts at an entry price of $100 per contract and exits at an exit price of $105, their total profit would be calculated as: (5 x ($105 – $100)) – Fees = Profit.
It is also important to note that due to margin requirements, traders must ensure they have enough funds in their account before entering into a trade to cover any potential losses. By understanding how to calculate each trade’s potential profit or loss, investors can make more informed decisions when evaluating potential trades and ensure they are correctly managing their risk.