DEMYSTIFYING THE WORLD OF DERIVATIVES
We all know that the financial world is full of uncertainties and risks. To survive in an unpredictable market, investors need certain financial instruments to mitigate the risks that they are facing.
To mitigate this risk, modern finance has come up with a method called hedging. Derivatives are widely used to hedge against risks and uncertainties, although not limited to just hedging.
Derivatives have been increasingly gaining significance in the financial market. The popularity of derivatives has grown manifold since the year of 2000.
Here is an infographic for a quick overview of the derivative market and the difference between market makers and direct market access (DMA):
What is a derivative?
A derivative is a financial security with a value that is derived from or reliant upon an underlying asset (eg: bonds, currencies, commodities, stocks, interest rates) or a group of assets (like index). Derivatives can be used as hedging tools to reduce risk and improve returns for both investors and organizations. Investors who are risk-averse will most likely use derivatives to enhance safety.
Types of derivative
Derivatives are also broken down into a few categories:
However, we are not going to dive into details for every category in this article.
What Are The Use Of Derivatives?
The most critical usage of derivative is to transfer of risk from risk-averse investors to investors who have a greater appetite for risk. Investors who are risk-averse often use derivative as to enhance safety.
Profiting from shares that are lying idle
Investors who would like to hold on to the shares that they bought for the long term can use derivatives to take advantage of the price fluctuations in the short term.
Protect your securities against fluctuations in prices
Investors can hedge against a fall in the price of the shares that they possess. This action is called hedging – investors are protected from a rise in the price of the shares that they wanted to buy.
Benefit from arbitrage
Scalpers can take advantage of the differences in prices in the two markets – we call this arbitrage trading.
Who are the players in the derivatives market?
Hedgers are players who would want to protect themselves from the risk involved in the fluctuation of the price movements. They hedge the price of their assets by making an opposite trade in the derivatives market.
Speculators are the ones who analyze and forecast future price movements as well as trading contracts to make profit. They purchase contracts and sell them at a higher price than the initial price that they purchase. A profit is made, if successful.
Margin-traders do not pay the total value of their position in the derivative products upfront – they buy on margin, which means they borrow money from a broker to purchase the derivative products. In this case, only a small deposit is required to hold a large outstanding position.
However, there is also a limit on how much one can borrow as the leverage factor is fixed.
An arbitrageur is one who attempts to profit from price inefficiencies in the market – they profit from making simultaneous trades that offset each other to capture risk-free profits.
Market Makers VS Direct Market Access (DMA)
Who are the Market Makers and DMAs?
We are often confused between the role of brokers and market makers – do take note that market makers and brokers are slightly different. However, it is often the case that a market maker is also a broker.
A broker is an intermediary that buys and sells securities on clients’ behalf. They make money by bringing securities’ buyers and sellers together. Only licensed brokers are allowed to make purchases of stocks on clients’ behalf. Licensed brokers will receive a flat fee or percentage-based commission for carrying out the trade and seeking for the best quotation for a security.
Market makers, on the other hand, are member firms appointed by the stock exchange to inject liquidity and trade volume in stocks to provide more fluid and efficient trading. Generally speaking, they are large investment companies that buy and sell securities through an electronic network. Market makers are always ready to buy and sell as long as the investor is willing to pay a specific price. The prices that market makers set reflect the demand and supply of the market. Market makers have to take the opposite side of your trade as counterparties for each transaction in terms of pricing. The rates that market makers set are based on their own best interest. They are obligated to buy and sell at the price and size that they have quoted.
On the hand, direct market access, DMA for short is an electronic trading facility that allow investors to make trades in financial instruments directly with the order book of an exchange (direct market access). Generally speaking, only broker-dealers and market maker firms are allowed to trade on the order book. With the aid of DMA, the trade is executed immediately at the final market transaction phase by the brokerage firm.
How do Market Makers and DMAs make money?
Market makers profit from the spread that is charged to their customer. The spread is simply the different between the bid and the ask price, which is often set by the market makers. The spreads are often set at a reasonable figure due to stiff competition with other market makers. There are times where market makers may hold your order and trade against their customers.
Take note that there are 2 main types of market makers – retail and institutional. Institution market makers normally comprises of banks or large corporations that offer bid/ask quote to other financial institutions, ECM or even retail market makers. Whereas, retail market makers, on the other hand, offer retail trading services to individual traders.
DMAs like Electronic Communication Network (ECN) or Straight Through Processing (STP) profit from their customers by charging them a fixed commission for every each transaction they make. Apparently, commission is the only legal source of income for ECN/STP brokers. ECN/STP brokers do not make or set prices, therefore, the risks of price manipulation are reduced for investors.
ECN/STP brokers don’t profit anything from the losses investors/traders make. However, some ECN/STP brokers do try to profit using other alternatives such as adding markups to the orders. Markups are hidden to investors/traders, and just slip the price when they want to get in and out of the markets.
Advantages and Disadvantages of Market Makers and DMA:
Advantages of Market Makers
- Features like charting software and news feeds are usually free on the trading platform.
- Currency price movements are less volatile compared to currency prices quoted on DMA like ECN.
Disadvantages of Market Makers
- Market makers may trade against you and this may result in conflict of interest in the order execution.
- In the event of high market volatility, order placing systems may “freeze” and huge amount of slippage might occur when news is released.
- Scalpers might not get filled at the prices they desire, hence “manual execution” might be needed in situation like this.
- Market makers might try to manipulate the prices and cause their customers to hit their stop loss or prevent their customers from reaching their profit objectives.
Advantages of DMA
- DMA’s usually provide a better bid/ask prices as they are derived from several sources.
- Sometimes, traders/investors will encounter little or no spread on their trade.
- Usually DMA brokers will not trade against you, as they will pass your orders to the opposite side of the transaction.
- It’s favorable for scalper, since prices might be more volatile.
Disadvantages of DMA
- Traders are required to pay commissions for each transaction they make.
- Their trading platforms tend to be less user-friendly.
- Features like charts and news feeds are often not offered on their trading platform.
- Difficult to calculate stop-loss in pips in advance due to the variable spreads of the bid/ask prices.
We hope that this article has given you a better understanding of the derivatives and the difference between market makers and direct market access (DMA)
Previously, we’ve also written an article about the 2008 financial crisis and how it affects the rest. Check it out here.
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