Firstly, it’s important to lay down a base level of knowledge. This is to make sure you understand what is being talked about later in the course when we start moving into the more intermediate and advanced topics.
There is a fair amount of terminology to learn with options so this section will be a little definition heavy. Stick with it though, and don’t worry if you can’t quite visualise how everything connects together yet, because we will be going into much more detail and coming back to these definitions in later sections.
Trading an asset directly
The most basic form of trading is buying and selling an asset directly. This asset could be real estate, another currency, gold and silver bars and coins, stocks and shares, or even new digital assets such as bitcoin or other cryptocurrencies. When trading an asset directly, you will exchange the currency or asset you already own, for another.
For example, you may have some dollars and wish to purchase some bars of silver. You may wish to do this because you expect these silver bars to appreciate in value. You will go to a silver bullion dealer, pay them your dollars, and they will give you your shiny new bars of silver. You now own and possess the silver bars, and no longer own or possess the dollars you used to pay for them. You have exchanged the dollars for the bars of silver in a single transaction, with no further rules or obligations.
What is a derivative?
A derivative is a contract that derives its value from an underlying asset. This underlying asset could be silver for example. It allows traders to speculate on the price of the underlying asset, without having to buy or sell the asset itself.
A derivative contract can take several different forms, for example a futures contract, or an options contract. Whatever the details though, a derivative contract is a legal agreement between two parties to buy or sell some underlying asset, according to the parameters laid out in the contract.
In our previous example you purchased some silver directly, and in doing so you would benefit from any subsequent increase in the price of silver. It is possible to get this same exposure to the price of silver without purchasing the silver itself though. This can be done by utilising a derivative contract that derives its value from silver. Silver here being the underlying asset.
For example, let’s say silver is trading at a price of $20/oz and you were considering purchasing 10,000 troy ounces of silver. To purchase the silver directly you would need to pay the bullion dealer $200,000 (plus any premium which we’ll come on to shortly), then either store the 10,000 ounces with a company that handles storage, or take physical delivery of the 10,000 ounces yourself.
If the price of silver then increases to $30/oz, you can sell the 10,000 ounces for $300,000, and so will have made a profit of $100,000.
However, you could use a silver derivative contract instead of purchasing the silver directly. You’ll still be able to make the same profit (or likely even better as we’ll discuss), but with several key benefits.
A futures contract is an example of a derivative contract you could use. By purchasing a silver futures contract, you are not purchasing the silver itself, but you are entering into a legal agreement to purchase the silver at some future date. These futures contracts will track the price of the underlying asset, which in this case is silver. You are free to sell this futures contract before the contract expires to realise any profit (or loss) you’ve made.
The CME silver futures contracts for example represent 5,000 ounces of silver per contract. So, instead of purchasing 10,000 ounces of physical silver you could purchase 2 CME silver futures contracts. This would give you the same price exposure to 10,000 ounces that you wanted, but without the need to arrange storage. If the price of the silver futures contract then increases to $30/oz, you can sell the 2 futures contracts for $300,000, and so will have made a profit of $100,000.
So why would a trader prefer to use the derivative contract?
In our simple example you made $100,000 whether you bought the physical silver or used the silver derivative, so why would someone choose to use the derivative? Firstly, we ignored transaction costs in the example. In reality, the profit from purchasing the physical silver would likely be drastically reduced by several factors.
Physical silver often has a premium added on by the bullion dealer. Depending on which country you live in and how large the current demand for silver is, this premium could be anywhere from a few percent to 30%+. You may also have taxes to pay. In the United Kingdom for example there is 20% VAT to pay on top of the purchase price for physical silver.
In our example where you purchased 10,000 ounces at $20/oz for a total of $200,000, you could end up paying as much as $260,000 if the premium and taxes add up to 30%. If you then sold the silver for $300,000 as before, you would only make a profit of $40,000 instead of $100,000!
You will also have to worry about the cost of transporting the silver, as well as the cost of storing it. You can purchase a safe and store it yourself, which may cause security and insurance issues. Or there are companies that will store it for you, but this will come at an extra cost depending on how long you store it with them.
Using a derivative contract instead, in this case the silver futures contracts, avoids all these costs. The futures contract may be trading at a slight premium to the spot price, but this will normally be considerably lower than the premium for physical silver. There is also no cost to store or transport the futures contract. You simply hold it in your trading account until you wish to close the position.
Derivatives also add the possibility of using leverage which can be of huge benefit to traders when used correctly. When purchasing the physical silver you needed to send the full $200,000 to the bullion dealer. When purchasing the futures contracts though, your broker may allow you to purchase them with leverage. Even a modest amount of 2x leverage would allow you to gain the same price exposure to 10,000 ounces of silver with only $100,000 in your trading account. We will cover this in much more detail later in the course, so don’t worry if you don’t quite follow this point on leverage yet.
We have only looked at a single simplified example so far of course, but the take away in this first lecture is that derivatives contracts allow traders to structure trades that suit their needs, while also avoiding many of the disadvantages of purchasing physical assets.
Summary
In summary, a derivative contract allows a trader to gain exposure to price movements of an asset without having to buy or sell the asset directly. The value of the derivative contract will be in some way tied to the price of the underlying asset, according to the terms of the contract.
Trading the underlying assets directly can be expensive and inefficient. Derivative contracts solve these problems. In the case of option contracts, which we will move on to next, they even allow completely new trades to be executed that would simply not be possible trading the asset directly.