What is derivative trading?


Quick Answer

Derivatives trading is the buying and selling of derivatives, which are multi-party contracts that derive their value from an underlying financial asset or entity. These entities are often commodities, such as oil, grain, bonds, stocks and currencies, or more abstract entities, such as interest rates or market indexes, according to Investopedia. Derivatives traders make money by betting on the increase or decrease in value of a derivative's underlying entity, explains The Atlantic.

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Full Answer

Derivatives can be used for hedging purposes. For example, a farmer may protect his grain crop at the beginning of the growing season by agreeing to sell it, upon harvest, to a particular customer at a particular price. If this customer is a baker, then both the farmer and baker are protecting their businesses. The farmer is protected if the price of grain drops during the growing season, while the baker is protected if the price rises. In exchange for this protection, the farmer gives up potentially higher revenue from increasing prices, and the baker sacrifices potentially lower costs. This kind of derivative is called a future, according to Investopedia.

If, instead of using the grain for his business, the farmer's customer turned around and sold the grain to others, he would be acting as a derivatives trader. A derivatives trader, in this case, would bet that the price of grain would increase and use a derivative to lock in lower-priced grain, making money on the grain's increased resale price. Many financial entities can take the place of grain in a derivative, and they can be based on particular actions or outcomes, rather than time periods, explains The Atlantic.

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