This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
A derivative is a contract whose value is derived from an underlying asset, like a stock, an index, or a commodity. The contract gives the holder the right or the obligation to trade the underlying asset at a future date or at a future price. The most common derivatives for stock trading are contracts for difference (CFDs), futures, and options.
What a derivative is
A derivative is a contract whose value is derived from an underlying asset, like a stock, an index, or a commodity. The contract gives the holder the right or the obligation to trade the underlying asset at a future date or at a future price. The most common derivatives for stock trading are contracts for difference (CFDs), futures, and options.
The appeal of derivatives is leverage. A small deposit can give the trader exposure to a much larger position, and the leverage amplifies both the gains and the losses. The trader who uses derivatives for stock trading should understand the leverage mechanics, the margin requirements, and the risks before opening the first position.
Contracts for difference
A CFD is a contract between the trader and the broker. The contract pays the difference between the entry price and the exit price of the underlying stock. The trader does not own the stock, and the trader does not receive the dividends, although some brokers adjust the position for dividend payments.
CFDs are leveraged by default. A broker may require 5 percent to 20 percent of the position value as the initial margin, and the rest is borrowed from the broker. The leverage amplifies the profits and the losses, and the trader can lose more than the initial deposit if the position moves against the trader.
CFDs are popular with short-term stock traders because the spread is tight, the commission is low, and the position can be opened with a small deposit. The trader should check the broker's margin policy, the broker's overnight financing rates, and the broker's stop-out level before opening a CFD position.
Futures
A futures contract is an agreement to buy or sell the underlying asset at a future date at a price agreed today. Futures are traded on regulated exchanges, and the exchange sets the contract specifications, the margin requirements, and the daily settlement process.
Futures are leveraged through the margin system. The exchange requires an initial margin, which is a percentage of the contract value, and the exchange marks the position to market every day. The mark-to-market process produces the variation margin, which is the daily profit or loss on the position.
Futures are popular with stock traders who want exposure to stock indices, single-stock futures, or the VIX. The trader should know the contract size, the tick value, and the last trading day before opening a futures position. The trader should also know the margin call procedure and the risk of forced liquidation.
Options
An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a strike price before the expiry. A call option gives the right to buy, and a put option gives the right to sell. The buyer pays a premium, and the seller receives the premium.
Options have a non-linear payoff, and the leverage on options is in the premium. A small premium can give the trader exposure to a large move in the underlying stock, and the leverage is high when the premium is small relative to the stock price. The trade-off is that the premium can expire worthless if the stock does not move in the expected direction.
Options are popular with stock traders who want to hedge a position, who want to bet on volatility, or who want a defined-risk trade. The trader should know the option chain, the strike prices, the expiry dates, and the Greeks before opening an options position.
How to choose the right derivative
The choice depends on the trading goal. CFDs suit short-term traders who want leverage and a small deposit. Futures suit traders who want exchange-traded exposure, transparent pricing, and the ability to go short. Options suit traders who want defined risk, hedging, or exposure to volatility.
The trader should also consider the cost. CFDs have a spread and an overnight financing charge. Futures have a commission and a margin interest. Options have a premium, which is the maximum loss on the trade. The total cost should be compared to the expected profit, and the trade should not be entered if the cost is too high.
Common questions about derivatives
What is the most leveraged derivative? Options are the most leveraged, because the premium can be a small fraction of the underlying price. The leverage is high, and the risk of total loss is also high.
Can I lose more than my deposit with derivatives? Yes, with CFDs and futures. The position can move against the trader, and the broker can demand additional margin. The trader should use a stop-loss to limit the loss.
Are derivatives regulated? CFDs and futures are regulated in most jurisdictions, and the regulation covers the broker's operations and the broker's handling of the client funds. Options are regulated in some jurisdictions, and the regulation varies by country.
Related resources
Where to start
If you are evaluating derivatives, the most useful first step is to open a demo account at a regulated broker, and to place a small CFD or option trade on a stock you follow. Our broker comparison lists the brokers that offer derivatives and the available products, which together tell you what the platform looks like before you place the first leveraged trade on a live account.