What are traditional financial derivatives?

What are traditional financial derivatives?

Financial derivatives by definition, and in classical terms, are contracts between two parties wherein one-party benefits at the expense of the other when predicting the future value of a financial asset. A financial asset can be a commodity (e.g. Gold, Oil), a stock (e.g. Apple, Amazon), an index (e.g. NASDAQ, FTSE 100), a foreign exchange (forex) pair (e.g. USDGBP, EURCHF), cryptocurrency (e.g. Bitcoin, Ether), etc.

Who issues derivative contracts?

These financial derivative contracts are traditionally/currently issued by centralized institutions and banks (e.g. Goldman Sachs, UBS, etc.) and are sold to individual market participants, be it traders or other institutions. When derivative contracts are sold between two large companies or institutions, this gets termed as institutional derivatives trade, commonly referred to as OTC or Over the Counter. When these derivative contracts are sold to individual market traders these are termed as retail derivatives trade, commonly referred to as OTE or Over the Exchange.

OTE or Over the Exchange implies that a trader buys these financial derivative contracts at the different exchanges or platforms where these derivative contracts are made available for traders to purchase.

Now imagine this. You are a derivative issuer like Goldman or JP Morgan and you create and sell derivative contracts for price of Apple stock at the end of the month. You do not just create a handful contracts. You create many contracts and sell them to thousands of traders.In doing so, you are always the counterparty that pays these traders when they are right in the predictions they made.; but you also make money for every trader that gets it wrong.

How do the derivative issuers make money?

The only way you, Mr Goldman, make money is if your exposure from selling all these contracts is balanced off such that the contracts on the upside offset the contracts on the downside and you make money from managing this risk and charging the contract price premiums and pricing in between the spreads.

This seems to be a very risky business, right? Who in the right mind would take on such heavy risks? How do they even know if they will make money?

Research tellsus that traders lose money on more than 75% of their trades, and the centralized derivative issuers almost always turn out a profit from their derivatives operations.

The news, general information, and mental faculties available to the people at centralized financial derivative issuers is the same as that of the individual traders. Do not believe for a second that the guys at Goldman and JP are smarter than the average trader. They are not.

But they, the centralized derivatives issuers, do have access to additional information that the normal Joe does not. See, if you are a trader you absorb all the information you can, then you apply your intellect and knowledge to analysing it all and forming an option on where a market is headed. What you do not know is what rest of the traders are thinking. You only know what you are thinking, and you rationalise it the best you can.

Advantage of Crowd Wisdom to Derivatives Contracts Issuers

What Goldman and JP (and everyone in the centralized derivatives issuer ilk) have is the crowd wisdom that is generated by them selling the hundreds and thousands of derivative contracts to the hundreds and thousands of traders. Imagine you suddenly knowing what a thousand traders are predicting and where they are buying their derivative contracts. Suddenly, you have a wealth of new information that you didn't have, which you can put to good use and no longer lose money more than 75% of the times.

It is this combination of access to crowd wisdom and structured risk management that is used to influence the traders and the trades they make, thereby helping the centralized derivatives issuers make money, and tons of it. For example, if they see a lot of traders buying call options, they will incentivize buying put options to balance their risk exposure by making puts cheaper and calls more expensive (through spreads and price premium mechanisms).

Wouldn't it be great if there was a way to level this playing field? If you could see the same crowd wisdom as Goldman and JP can see? Well wait no more. CloseCross.com provides an impartial regulated platform where traders can visualise the crowd wisdom at all times and enter contracts against other traders (not the centralized issuers). Check out the easy to digest crowd wisdom chart for all assets and all time horizons in a blink of an eye at CloseCross.com

Take a test drive of the blockchain based financial derivatives market today on closecross.com

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Written By
Vaibhav Kadikar
Founder, CloseCross - Decentralized derivatives driving democratic participation