Derivative Trading | How to Trade Derivatives in 2024

Trading derivatives is a popular way to take your investing to the next level. With derivatives, you can add leverage to your trades, speculate on the future price of non-traditional assets, or create complex trades across currencies. While derivatives add some risk, they can also dramatically increase your returns from investing.

Derivatives can be tricky to understand when you’re just starting out with trading them. In this guide, we’ll explain how you can get started trading derivatives right away and highlight our three favorite brokerages for buying and selling contracts. We’ll also cover the basics about the different types of derivatives that are commonly available so you can better decide what style of derivative trading is right for you.

Step 1: Open a Derivative Trading Account

The first step in trading derivatives is to open an account with a brokerage that offers different types of contracts. We’ll go into more detail on the different types of derivatives you can trade below. But, when choosing a brokerage, keep in mind that not all brokers offer the same types of derivatives for all the same assets. You’ll need to carefully consider what assets you want to trade and how.

With that in mind, let’s take a look at three popular brokers for derivatives trading.

Step 2: Understand Derivatives

Before you dive headfirst into trading derivatives, it’s essential that you understand exactly what you’re trading. There are many different types of derivatives, since they exist for almost every market and it’s possible to create and trade derivatives of derivatives. Here, we’ll take a closer look at four of the most common types of derivatives and how they work.

Contracts for Differences (CFDs)

CFDs are one of the most widely traded types of derivative, in part because they can be easily applied to just about any underlying asset. With a CFD, you are simply speculating on whether the price of an asset will go up or down from the time you purchase the contract. For every percentage point the price of the underlying asset moves up or down, the value of your contract moves up or down a percentage point (or multiple points, if you’ve applied leverage).

CFD contracts are typically written for one month at a time. But, most brokers will roll them over into a new month’s contract free of charge. So, these derivatives are not time-dependent in the way that many other types of derivatives are. Just beware that brokers will typically charge interest fees if you hold a leveraged CFD position overnight.

Options

Options are a frequently traded derivative for stocks. With an options contract, you have the option, but not the obligation, to purchase shares of the underlying stock at the price set out in the contract at any time before the contract’s expiration date. You can use options to hedge existing positions or to make highly leveraged bets that the price of the underlying asset will rise above or fall below the strike price of the contract.

Critically, since options expire, their value is heavily influenced by the time remaining to expiration. Take, as an example, an out-of-the-money call option, which gives you the option to buy a stock at higher than its current market price. This unprofitable option is worth a lot less when it’s going to expire tomorrow, as opposed to if it will expire next month and the stock price has time to rebound before the expiration.

Futures

Future contracts are a lot like options, except that you must exercise the contract on the expiration date. You cannot decide not to buy or sell the underlying asset, and your purchase or sale must occur on the contract’s expiration date. Futures are commonly traded around commodities, since farmers, oil companies, and other entities can use these derivatives to hedge their own risk against changing market conditions.

Swaps

Swaps are another very popular type of derivative that are often used to hedge risk or speculate on currency and interest rate markets. With a swap contract, you can, for example, lock in the exchange rate for a currency trade to protect an investment in a foreign currency. Swap contracts can also be used to switch between fixed and variable interest rates, such as on a loan, in order to protect against potential changes in market rates.

Step 3: Choose a Derivative Trading Strategy

Derivative trading carries with it a significant amount of inherent risk. So, it’s important to have a well thought-out strategy to protect yourself and ensure that your trades will be profitable.

There is a huge number of factors to consider when developing a derivative trading strategy, and every trader will have a different approach. But, to help you get started, here are some of the things you should consider when starting to trade derivatives.

Timeframe
The first thing to consider when trading derivatives is what your timeframe will be. For many types of derivatives, and especially options and futures contracts, the timing of price changes in an underlying asset is just as important as the price changes themselves. This doesn’t mean that shorter-term or longer-term contracts necessarily carry more risk, but it’s essential that you have a good idea of when you expect a price change to occur before trading derivatives around that price change.

This isn’t necessarily true to the same extent when you’re trading CFDs, since they don’t have a hard expiration date. But, if you’re opening leveraged positions, then time is of the essence since brokers will charge an interest fee every night that your position remains open. Leveraged CFD trades, then, are popular for day traders or intra-week traders.

Technical vs. Fundamental Analysis
Another thing to consider is whether you want to trade based on technical data or fundamental data. Technical data largely focuses on recent price movements and mathematical indicators to try to predict where an asset’s price will be heading next. Fundamental data, on the other hand, looks at supply and demand or company financials for an underlying asset to determine what it’s really worth, regardless of the current asset price.

Both approaches have their merits, and many traders use a combination of technical and fundamental trading. But, when trying to put together a derivative trading strategy, it’s important to recognize the differences between these techniques.

Step 4: Open a Derivative Trade

Now that you know how to find a derivative trading brokerage and understand more about derivative trading, it’s time to open a trade. We’ll illustrate the process for opening a CFD position around the price of crude oil. Before getting started, make sure that your account has been opened and funded.

 

To trade oil CFDs, search for ‘Oil’ in the markets search box. From the oil page, click ‘Trade’ to start setting your trade parameters. Your options are to buy crude oil CFDs if you think the price of oil will rise or to sell crude oil CFDs if you think the price will drop. You can also decide whether you want to apply leverage to your trade to buy more contracts with less money, and whether you want to set an automatic stop-loss or take-profit level. When you’re ready, click ‘Open Trade’ to execute your trade.

 

Conclusion

Derivatives are frequently used by traders to increase their exposure to a specific asset and to hedge bets on new or existing positions. With derivative trading, you can dramatically increase your return through leverage, but keep in mind that your risk is also multiplied.

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