When it comes to forex trading, there are a few key types of foreign exchange derivatives that you should be familiar with. We’ve put together a handy guide so you can gain a better understanding of CFD derivatives.
What is a derivative?
Within the trading and finance profession, a derivative refers to a financial security whose value depends on an underlying asset. The type of underlying asset may include market indexes, interest rates, currencies, commodities, stocks or bonds. In essence, a derivative contract is one that allows you to buy and sell types of financial instruments or non-financial assets (as previously mentioned).
You may trade your derivatives over the counter (OTC), however this is generally unregulated and holds greater risk. Alternatively, you may trade on an exchange, when tends to be more standardised.
1. Forward contract
A forward contract is a binding agreement to buy or sell an asset:
- At a specific price
- On a specific date
The asset being traded can be anything of value such as currencies, stocks, bonds and metals, or even agricultural materials like corn. When it comes to a forward contract, the profits and losses are only realised and paid out when the contract expires. Furthermore, these contracts are usually traded OTC as opposed to on exchanges.
2. Futures contract
Like a forward contract, a futures contract is an agreement to buy an sell an asset:
- At a particular price
- On a particular date
Unlike a forward contract however, the profits and losses on these contracts are realised and paid out at the end of each day, rather than when the contract expires. Essentially, this makes a future contract a standardised forward agreement, as the futures contracts have set maturity dates and are traded in standard sizes.
Options give the holder the right to buy or sell a specific asset at a specific price on a specific date. However, unlike forward and futures contracts, there is no obligation for the holder to act. There are two types of options:
- Call option: represents the right to buy
- Put option: represents the right to sell
Depending on your strategy, you can put these options to work for you. For example, purchasing a call option could be used as a safeguard against the risk of rising exchange rates, whereas a put option is best used against the risk of falling exchange rates.
When it comes to CFD derivatives and trading, it’s important to educate yourself on the many options available to create the right strategy for you. Get in touch with the team at ForexCT today and discover how you can start trading with confidence.