Often confused as same, shares and derivative trading differ from each other. Shares and derivatives are traded separately. Shares and derivative trading have different advantages and disadvantages. However, the two can also be combined to enhance the trading strategy of one another.

Shares trading is buying and selling shares of a company in a short duration. Trading in derivatives involves buying and selling contracts that grant the right or obligation to buy and sell the underlying asset before expiry.

Most of the newcomers in trading begin with stock trading. Some traders may solely trade on derivatives. However, experienced traders generally tend to involve derivatives in their stock trading strategies. Each type of trading instrument is ideal for different types of investors.

What is Stock and Derivatives Trading?

Stock trading is buying and selling shares of a company. The shares are traded in a short duration to book profits. Derivatives on the other hand can involve multiple capital instruments as an underlying asset.

What are Shares?

Owning shares of a company represents part ownership of the business. A share is the smallest unit of the entire equity of a business. The shares are traded via an exchange that acts as an intermediary to connect buyers and sellers. Nigerian Exchange Group (NGX) is the only stock exchange in Nigeria where 156 stocks are listed.

The price of shares depends mainly on the business activities of the concerned share. Growth or expansion of the business drives the share prices upward. Decisions or activities that result in a loss for the business can pull down its share prices. A sudden spike in demand or supply of the stock can also trigger dramatic price movements.

What are Derivatives?

Derivatives are financial instruments that derive their value from other capital markets.

Derivatives can be of multiple types depending on features and obligations. Each derivative instrument is based on the price movement of its underlying asset. Derivatives are used for hedging as well as speculation. Derivatives can be of different types like Futures, Options, OTC or CFDs.

In Nigeria, derivatives are available at NGX while CFDs are offered by foreign regulated CFD brokers.

Types of Derivatives

Following are the most popular types of derivative instruments used by retail traders.

• Futures: The holder of the futures contract has the right and obligation to exercise the contract at the end of predefined tenure. It is an agreement between buyer and seller to transact at a specific price at a specific time in the future.
• Options: Option contracts are similar to futures. The basic difference is that the holder has the right but not the obligation to exercise the contract. The holder of the contract has the option to choose whether to exercise the contract or not before the expiry date. The premium paid to buy the contract is the only loss to the trader in case the contract is not exercised.
• CFD: It is a much convenient type of derivative instrument where only the price movements of the underlying asset are speculated. There is no physical buying and selling of securities, unlike futures and options. Currencies, International Commodities, shares, indices are popular form of instruments that are traded as CFD contracts online by Nigerian day traders. Forex Trading in Nigeria is done through foreign regulated CFD brokers and there are estimated to be 240,000 traders in the country who trade CFDs and Forex online regularly. But it is important to note that CFD trading is not yet regulated in Nigeria so the traders in Nigeria mostly trade CFDs through foreign Tier-1 regulated CFD brokers i.e., brokers that are regulated with FCA, FSCA, ASIC, BaFin.
• OTC Derivatives: Some derivative instruments like forwards and swaps are traded over the counter. This means that the two parties mutually agree to a contract specifying the terms of buying and selling.

Basic Difference Between Shares and Derivative Trading

Following are the major difference between shares and derivative trading from a trader perspective.

Investing Strategies

There are different strategies to trade with each financial instrument. The strategies to trade stocks and derivatives are different. Analysis and research are required in stock as well as derivatives trading.

Stock trading strategies include swing trading, news trading, day trading, position trading, etc. Each strategy is followed by different types of traders.

Derivative trading strategies can be grouped under 2 categories. Traders use derivative instruments either to hedge against sudden price movement or speculate to book profits. Some of the commonly used derivative trading strategies include covered call, protective put, straddle options, butterfly spread, etc.

Leverage

Leverage is an important factor separating stock and derivative trading. Leverage can be thought of as debt or borrowed money used for trading. A leverage of 1:100 will allow traders to book 10% gains on a 0.1% price increase of underlying assets.

In general, there is little or no leverage on stock trading. Some brokers do offer leverage on stock trading. The impact of leverage on derivative trading is comparatively much higher.

Most of the derivatives like options, CFDs, etc involve significant leverage. This allows traders to open large positions or trade with a large amount with smaller deposits.

Leverage makes derivatives trading more rewarding as bigger gains can be booked with smaller deposits. Although, this also increases the risk factor as the losses are also leveraged.

Risk

The risk factor is different for each trading instrument. Stock trading is generally considered less risky than derivative trading. However, the risk factor in derivative trading, as well as stock trading, can be mitigated up to great extent by enhancing strategies and precautions.

The risk factors associated with stock trading are transparent and can only affect a portion of the invested amount. In derivatives, multiple risk factors can greatly affect the outcome of a trade. Traders can also lose all of their deposited amounts while trading with derivatives.

Value/Yield

Shares of a company can be traded in a short duration but can also be left for a longer period. There is no expiry date in stock trading. Apart from the speculative gains, traders can also earn a dividend paid by the stocks. The extent of gains in stocks is comparatively narrower than derivatives due to lesser leverage.

Derivative trading can yield a high return with small deposits. In the case of premium-based derivatives, only the premium amount is at the risk but the gains can be exponential. Each derivative contract can deliver different yields.

Volatility

Shares as well as derivatives trading are based on volatility. Traders can take advantage of the volatility but extreme volatility also brings high risk.

The stock market is considered less volatile when compared with the derivative market. Leverage plays an important role in increasing the effects of volatility on the outcome of the trade.

Experienced traders tend to take advantage of high volatility in derivative instruments. Highly volatile markets may not be ideal for some of the traders.

Short Position

A position in which traders earn a profit if the prices go down is called a short position. Opening a short position in stock trading is complex.

Traders need to seek the brokers that offer a short position in stocks. The short position in stock trading also requires a high margin if offered by the broker. Traders need to repay the stocks to the broker at prevalent prices if they have shorted them before. It is not possible to go short in the stock market with some brokers.

In derivatives, opening a short position is as simple as opening a long position. The margin, fees, commission, leverage, and all other features or obligations, are similar for going short and long in derivatives.

Variety of Instruments

Shares of listed companies are the only available instruments in stock trading. A lesser number of trading instruments restricts the opportunities available to make profits.

The number of instruments in derivative trading is much higher compared to stock trading. Each derivative contract is a different instrument in itself. There can be hundreds of contracts on a single stock or commodity with different expiry, strike price, spot price, quantity, etc.

Variety in trading instruments provides plenty of opportunities to the trader. Traders can opt to trade with the most suitable derivative instrument. The variety of trading instruments is much lesser in stock trading.