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Updated on: 16 April 2018

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Entering derivative trading

Okay, so you have grown a bit in terms of understanding how the world of trading functions. You have your basics down, along with a firm grasp of how trading markets work and what you need to do to succeed. Now we move one step further and dive straight into the heart of the trading industry.

Which means today we are going to talk about what an underlying asset is, the most common types used in the trading business and how underlying assets function. But we can’t do that without explaining derivatives trading first. Let me tell you right now that this is where we prepare to step into the grownups’ league.

Derivatives are thought to be some of the most complex financial instruments you can stumble upon. This being said, you can’t simply skip them because of their complexity, because they play a major role in defining how underlying assets work. And, in the world of trading, these are the bread and butter of any serious, professional trader.

In essence, derivatives are financial contracts, whose value depends strictly on that of an underlying asset. In other words, derivatives derive their value from them. Hence, their name. How derivatives work? Well, in essence, they help you make profit by betting on the future potential value of any given underlying asset that the respective derivative operates on.

The meaning of underlying asset trading

I assume I don’t have to give you the definition of underlying asset, right? Because it is as easy as reading the definition of derivatives backwards. Mainly: the underlying asset is a financial instrument that a derivative bases its value upon. This is the easy part, and I say this, because I can already tell what you are thinking – Easy definition, easy concept.

Actually, although the definition is pretty straightforward, understanding and being able to use the concept behind it is anything but. And the concept goes like this:

A given stock has the option to be sold or bought by the holder for a specific strike price, at the moment the stock’s expiration occurs. We call the company’s stock, in this case, the underlying asset. And, in the situation being portrayed here, the underlying asset is used to identify which item in the agreement imbues the contract with value. In other words, the underlying asset is the security measure, representing the parties’ consensus regarding the derivative contract.

But what will definitely help you better understand how underlying assets function is going through the most common types of underlying assets and detail on their profile and functionality. This being said, the most used underlying assets are: interest rates, bonds, stocks, currencies, futures, commodities and indices.

You will find a lot more on the trading market, depending on each broker in particular, but these are the most used, which means these are the ones we need to detail.

The most important types of underlying assets

I know there is a lot to chew on, but it is extremely important to build a solid foundation, otherwise you will have no chance of succeeding in the trading industry. What is an underlying asset? You already know that now. You might not control the concept, but at least you have the basic definition with you.

Now it’s time to go deeper.

1. Interest rate

In simple words, the interest rate is the amount of cash you need to pay to a lender, in case you decide to borrow some money. In the financial market the interest rate is usually expressed as a percentage and it is noted annually. The interest rate is common for any loan, regardless of the asset you are looking to acquire or the size of the loan itself.

The only thing that varies is the value of the interest rate. If you are considered a low-risk party, your interest will be low. If you fall into the category of high-risk parties, it will inevitably be higher.

We won’t go into details too much, because everyone pretty much knows what the interest rate is, how it works and the factors that make it vary from case to case.

2. The bonds

Bonds are used by corporate entities, governmental authorities or different states and companies to finance major projects that they cannot fund directly. For that purpose, they sell bonds to interested third-parties, based on a loaning contract, specifying that the lenders are to be refunded within a given timeframe under specific fixed or varying interest rates.

It is most likely that you are already familiarized with the concept of bonds but you didn’t know the exact definition yet. Well, there you go!

3. Stocks

The stock represents a contractual agreement between a company and a third-party that provides the said third-party with an ownership position within the company. As a result, the third-party will be entitled to a part of the company’s earnings, as specified by the number and the value of the stocks it receives. Usually expressed in percentages.

The trading market will greatly influence the value of each company’s stocks, which makes stocks one of the preferred target for many professional traders around the world.

4. Currencies

Currencies are extremely volatile, which makes them highly desirable among traders coming from all corners of the globe. According to the latest data, the forex market alone moves around $5 trillion every day, truly making it the trading honey pot among the connoisseurs.

Whether you go for major currencies or settle for the minor ones, it is guaranteed to have your hands full for quite some time.

5. Futures

Futures are pretty self-explanatory. They are financial contracts either forcing an asset onto a buyer or obligating a seller to sell one. Whether we talk about financial instruments or physical assets, the concept remains the same.

As you may have already guessed, futures have the power to detail the quality of a given underlying asset.

6. Indices

Indices, or market indexes, are basically indicators that track the performance of given stocks, assets or groups of assets, on the trading market. These are excellent tools to use for traders who are interested in major corporations stocks and can use these indices to make educated adjustments to their strategies.

7. Commodities

Easy to use and even easier to understand conceptually. Commodities are either hard or soft. The hard ones are those that need to be processed, extracted or created. This includes oil, rubber, gold and silver and so on. Soft commodities refer to livestock, or agricultural products, for the most part.

There are a lot of traders that deal with commodities, because they are generally easier to deal with and overall steadier than other underlying assets like currencies, for instance.

As I have already mentioned, these are just a few of what the trading market offers in terms of underlying assets options. Depending on the brokers, you can get access to a lot more, increasing your chances of finding something with a higher degree of appeal.

What is an underlying asset market like?

Well, the trading market operates on underlying assets in its entirety. The trick is to know which specific trading branch to enter and how to work within its universe. I know how difficult that can be, because I have walked in your shoes before. The key problem with the basic definition of underlying asset is that it tells you nothing about what to expect.

For instance, operating with shares is more rewarding than the alternatives, but also way riskier. Which means it is only suited for more experienced traders. Compared to that, trading with bonds is the safer way, but the gains are also lower.
It all comes down to understanding the basics and knowing where and how to start. And this is where the gauntlet starts, because there are a lot of aspects, regarding the trading market, that you need to focus on.

All I have done here is to provide you with some of the basics, so make sure to take what you need and baby-step your way to greatness.

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