In the field of finance and trading, a derivative is an instrument that is used for investment through a contract.
Its value is merely based upon that of another asset referred to as an underlying asset.
Therefore, its value changes with changes in the value of the underlying asset.
Among the several types of the underlying assets commonly used with a derivative include fixed-income securities, equities, currencies, credit events, and commodities.
Currencies can be traded in futures, spot, binary options, options (vanilla), as well as CFD (contracts for difference) market. Regulated exchanges only offer options (vanilla) and currency futures.
Binary options, on the other hand, are provided by both the OTC binary brokers and regulated exchanges. CFDs and spot forex are offered only on an OTC basis.
Therefore, the complex structure results in a high degree of doubt, especially for beginner traders about the instruments on which among them are derivatives and which ones are not. The following aspects will help you determine those that can be categorized as derivatives.
The process of settlement is different in all kinds of forex trading. For instance, if the settlement is based on an exchange rate of a given currency that is being traded in a different market, the market studied then is a derivative.
When we’re talking about spot forex trading, then a T+2 settlement is usually followed. It means that all the transactions are settled within 2 business days from the execution date.
However, there’re some exceptions of pair such as USD/TRY, USD/CAD, USD/KZT, USD/RUB, and USD/PKR, all of which settle at T+1. From the short-term settlement period, it’s clear that spot forex isn’t a derivative.
Usually, the currency options have extended settlement cycles. Moreover, settlement of currency option contracts within all exchanges is all based on the spot market price.
Therefore, the extended settlement cycle, as well as price identification mechanism shows that forex option contracts are merely derivative products.
Spot forex trading and CFDs share a considerable amount of similarities. A similar charting platform can be used by a trader and receive the same quotes. However, for CFDs, they’re mere contracts allowing a trader to bet only on a price change of an asset.
Unlike in spot forex trading, CFDs don’t result in delivery, and the price of a given currency in the CFD market trails that in a spot market.
Therefore, as a result of a lack of delivery as well as price identification, CFDs are entirely derivative products.
Trades in the futures market are usually settled after 30 days with contracts taking even more extended periods available as well; hence, futures are a derivative.
Some binary options contracts offered by binary brokers expire in minutes, with none of them leading to the delivery of the assets. Also, the settlement is on the price traded in a spot forex market. Therefore, the binary options are derivatives.
Trading time, volume, and order size
Derivative markets lay down restrictions or simply use standardized contracts on volume and order size. On a spot market, currencies are traded 24/5 without trade time restrictions.
Moreover, brokers don’t specify standard order size. Therefore, the restrictions on the trade timings, order volume, and lot size show that spot forex trading isn’t a derivative.
Currency futures can also be classified as derivatives because there’re restrictions like set trade hours as well as a specific maximum position size.
Also, like the currency futures, the traditional currency options contracts are derivatives, too, as they also have similar restrictions.
For binary options, classifying them as a derivative only by looking at market restrictions on order size, trading time, and volume can be difficult. Similarly, looking at the same parameter won’t be used only to classify CFDs as derivative contracts.
If the price of a given instrument in a market depends on the traded price in a different market, then that market under study is a derivative.
The spot forex trading is not a derivative as the exchange rate of a given currency isn’t derived from any given data. When looking at the exchange rate calculation, currency futures are classified as derivatives.
Options are generally derivatives as premium is merely calculated from the underlying price of a currency in the spot forex market.
Also, based on the exchange rate identification mechanism, the binary options are categorized as derivatives.
A rollover fee is usually applied for holding a given position in a pair to compensate every party for lacking the physical delivery of cash. When there’s an exchange of the assets, there’s no rollover, and hence that trading is under derivatives.
When a trader opens a position overnight, a rollover fee is applied, which can be either positive or negative, depending on the differentials between the given currencies. Hence, Spot forex is not derivative trading.
Since there’s no rollover or swap fee in the currency futures trading, they are categorized as derivatives. Similarly, traditional currency options have no overnight rollover fee and hence are derivative trading.
Binary options don’t incur a swap fee as there’s no real exchange of assets that are involved, and hence, they’re categorized as derivatives just like the CFDs.
Based on the exchange rate identification process, settlement mechanism, order size, trading costs, swaps, and trading time, spot trading isn’t a derivative. The other currency trading forms like binary options, futures, vanilla options, and CFDs are all derivatives.