Best practices in derivative trading
While you might be familiar with other types of trading, it’s important to note that derivatives have their own particularities. Here are some of the best practices in derivative trading to help you on your way.
What is derivative trading?
Derivatives are trading instruments that derive from the value of an underlying investment like commodities, stocks, forex, indices, etc. As a derivative trader, you do not own the underlying investment but do consider its price movement. You can trade instruments based on a variety of investments such as stocks, currencies (forex trading), indices, commodities, and cryptocurrencies.
How do you trade derivatives?
The first step is to open a derivative trading account with a broker giving you access to a trading platform that offers a wide range of financial instruments. Once your account has been created you can buy (go long) or sell (go short) any instrument that is available for trading.
If you believe the price of an instrument will go up in future, you might place a buy order at the current market price. When the price moves higher, you have the opportunity to close your open position at a profit. The execution is almost instant as the broker settles the transaction in seconds.
Let’s look at a couple of examples that help illustrate the above.
- As we approach the festive holidays like Christmas, the demand for groceries tends to push prices higher, so companies cash in on the seasonal buying spree. It means the profits of the company will also be reflected through a rising share price. You do not want to own the shares of the company year-round, but you do want to take advantage of its share price increase. So, you decide to buy the stock derivatives at the price of 100 rands a share anticipating a rise in the underlying instruments. In this example, and due to the rising demand for groceries, the stock price rises to 130 rands a share. You now have the opportunity to sell your contract back to the broker at a profit of 30 rands per share.
- In this next example, you anticipate that the price of oil will go down as geopolitical tensions ease, so you place a sell order at the current market price. When the oil price drops, you have the opportunity to close your open position at a profit. Remember this execution is done by the broker and you do not need to worry about how the transaction is settled.
Margin and Leverage in derivative trading
Margin is the amount you deposit into your account for trading. Brokers offer a variety of minimum deposits such as $10 or $100, while some are as high as $10,000. You might think that this makes trading some instruments prohibitive. However, this is where leverage allows you to get a piece of this action.
With leverage, the broker allows you to use borrowed funds while you use your margin as insurance against any future losses that may be incurred. Leverage allows you to profit from even small price changes in an instrument if the position heads in your direction.
The Cost of derivative Trading
Like in any other business of buying and selling, a derivative trader will incur the cost of doing business. Although the costs might be small, it is important to know how they will affect your ability to be profitable in the long term.
Spread – This is the difference between the current buy price and the selling price. This represents the amount brokers charge to open the position. The more an instrument is traded, the higher liquidity it has, meaning its spreads will be more narrow.
Commission – Unlike many other online trading activities, a derivative trader is usually able to trade with zero (or low) commission.
Inactivity Fee – This is a possible fee by some brokers should you not log in to your trading account for a specified period.
Best derivative Trading Tips
Now that we’ve defined derivative trading and how to do it, let’s look at the best practices.
Find a Regulated Derivative Broker
Choose to open an account with a regulated broker, as regulatory bodies like the FSCA, FCA, CySEC, ASIC and others offer trader protection.
If you’re new to trading, then begin your journey in derivative trading with a practice, or demo, account. The practice account will allow you to place orders on multiple instruments in real market conditions without committing your own funds. This allows you to understand how the markets work and become familiar with the trading platform. Any profits or losses are only simulated, and when you feel ready, you can open a live account by depositing your own funds.
How to minimise loses
You can minimise losses by using a stop loss order where you place a cap on losses if an instrument’s price goes against your expectations. For example, if you opened a trade to buy gold at $1950, anticipating that the price would go higher, and set your stop loss at $1945, the most you could lose on this trade is $5 of your margin.
Diversify your financial portfolio
The derivative trading platform allows you to trade various products from stocks, options, cryptocurrencies, currencies, and commodities. You can vary the degrees of risk by balancing more conservative instruments with ones experiencing higher market volatility.
Have a Strategy
You will need to learn how to analyse and trade derivatives using various tools available on your platform. Professional traders use both fundamental and technical analysis to understand instrument price movements. Fundamental analysis is the study of how political, social, and economic events affect the intrinsic value, strength, and sentiment of an instrument. Technical analysis refers to the study of the behaviour of prices in a specific timeframe. A hybrid strategy will combine fundamental and technical perspectives to make an overall judgment on the direction of the instrument.
Create a Trading Plan
Derivative trading requires you to have a plan which lays out which instruments you will be trading, the model of your top-down analysis, and how to manage your risk. This plan applies to professional and novice derivative traders as it is your rulebook for trading. It will guide you on how to manage yourself through both winning streaks and losses while directing you on how you can manage risk exposure on your portfolio of instruments.
Combine your trading plan with a trading journal so you can see how your strategies played out.
Create a Winning Mindset
Trading is not just about knowing how to predict the markets; it’s also about understanding how to control your emotions. Some of the common traps traders at all levels of experience fall into include the following:
- FOMO – fear of missing out. Seeing a trend that everyone is on and jumping in without having analysed the markets or checked in with your trading plan.
- Holding onto your losing trade for too long, or even worse, increasing your margin to avoid being stopped. It’s ok to accept some trading losses; the key is to minimise your losses.
- Letting fear take hold and missing out on potential opportunities. You’ve had a run of bad trades, and you’re hesitant to enter the markets again. Taking the time to relook where you went wrong is a great way to learn further from first-hand experience. You can always jump back in when you’re ready.
- If you’re new to trading, consider starting with lower leverage and increasing as you gain confidence.
Best practices for better trading
There are many good practices to follow when trading derivatives and some people have their own advice, like ‘the trend is your friend. In this article, we’ve outlined some of the fundamental practices for a rewarding trading experience, but as any experienced trader will tell you, there is always more to learn. So, keep learning, trade smart, and enjoy your journey.
Learn the terms
Underlying instrument– The underlying instrument is the financial instrument that a derivative instrument derives its price from.
Financial Portfolio – This is a collection of financial instruments that can include shares, real estate, bonds, cash etc. In derivative trading, your portfolio might include a mix of derivative instrument categories like currencies, commodities, indices, and cryptocurrencies.
Market Volatility – This is when markets or specific instruments experience unpredictable and/or sudden sharp price movements.