Our Top 4 Types of Derivatives in Forex Trading
Updated January 11, 2024.
Derivatives are financial contracts established by at least two parties, which will gain value from one or more underlying assets or benchmarks. In the forex market, a derivative consists of traders speculating on prices of the currencies without buying or taking delivery of these instruments.
1. Currency Options
In forex trading, there are two types of currency options—vanilla and exotic. What are these exactly? Let's find out.
A vanilla FX option offers investors the right(not the obligation) to buy or sell a pre-determined amount of one currency in exchange for another unit of money at an agreed-upon rate when the option is acquired within the given time limit.
Vanilla FX options may be beneficial due to the customization amid better risk mitigation. You garner more control and protection with vanilla options since there is less volatility and risk. You can also tailor your purchases to your investing needs and potentially combine these options with other instruments, like spot forex.
Its value will be determined by a broad array of factors, such as volatility of the underlying currency pair, expiration date, and strike rate.
Exotic forex options are different from traditional alternatives, from payment structures to strike prices to expiration dates. At the same time, they also provide FX traders with customization options to adjust their risk tolerance, profit levels, and flexibility.
The value of these options is derived from various sources, such as underlying assets, expiration dates, and payoffs.
» Want to learn more about currencies? See the differences between major and minor pairs
Contracts for differences (CFDs) are financial contracts between investors and financial institutions or investment banks. They allow traders to speculate on price movement without owning physical assets. The transaction pays the differences in the settlement price between the open and closing trades.
CFD is a popular over-the-counter (OTC) trading mechanism because it is generally cheaper to access and trade the price of an underlying asset than purchase the security. In addition, CFDs offer simple trade execution and the option to go long or short.
The value of a CFD-based trade is much like everything else in the financial markets—instruments are influenced by many factors, from monetary policy to geopolitical turmoil to events in the broader financial markets.
» Check out the main differences between CFDs and options
Exchange-traded funds (ETFs) are baskets of investments of stocks, commodities, or bonds that are bought and sold on the financial markets. It is much like a mutual fund, except you can buy and sell ETFs throughout the trading session at various prices. ETFs have surpassed mutual funds in terms of value and volume, becoming the favorite investment tool for retail and institutional investors.
Their values are derived from the individual underlying stocks and other assets that the investment banks have pooled. So, if a bank-focused ETF is dominated by JPMorgan Chase, Wells Fargo, and Bank of America, and these companies see their shares tank two percent in a single session, this ETF will plummet.
The risks are comparable to everything else in the financial markets, be it stocks or mutual funds.
» Learn more about forex currency pairs with Fortrade
4. Total Return Swap
A total return swap is a swap agreement that involves one party making payments on a specified rate (fixed or variable) to another party in exchange for the income or return created by an asset owned by the party. The party receiving the total return will benefit from the reference asset without taking delivery of the security. In addition, the receiving party gets to generate income garnered by the asset but will pay a set rate during the course of the swap.
The receiver takes on the risk, either credit or systematic, and the payer will endure the credit exposure.
This is not for beginner investors. This is more for seasoned veterans who have participated in the financial markets for years, if not decades. Remember, if the asset or index plummets, the payer will be required to make large payments.
Note: Fortrade offers the ability to trade the price changes of instruments with CFDs and NOT to buy/sell ownership of the instrument itself