If you are new to the world of options contracts, the best parallel example that explains them is insurance.

With insurance, we pay a small premium that we exercise at times of need. Financially speaking, the worst that can happen is for the year to go by and lose the premium without exercising any rights on it.

Irrespective of whether the insurance was needed or not, having it in place makes us owners of the right to claim, and the insurance company is tied by contract to settle.

Options contracts are exactly the same. Instead of claiming insurance money, we claim our right to buy or sell assets.

 

What are options contracts?

Options contracts are legally binding financial agreements, that give investors and traders the right, but not the obligation, to buy or sell an asset at a predetermined price, and before a specified date.

The asset is usually a stock, but it can also be an index, ETF, or other financial product.

 

What does “not the obligation” mean? This is what makes them “options”. Exercising (buying or selling) is at the discretion of the buyer/seller, and at the mercy of the markets.

 

This is distinct from futures contracts that must settle irrespective of profits or losses at expiry. Settlement with options contracts is optional.

 

Important parts and key terms of options contracts:

To fully understand options contracts, we need to know these key terms:

• Strike price
  • The agreed price that allows us to claim our right to buy or sell.
• Premium
  • The upfront cost that buys us the right to claim.
• Expiration date
  • The date options contracts expire, waiving the right to claim.

• In-the-money (ITM)
  • An option already has value if exercised right now. Think of a coupon that saves you money today.
• At-the-money (ATM)
  • The strike price is close to the current stock price. Think of it as a break-even.
• Out-of-the-money (OTM)
  • The option would not make money if exercised right now. Think of the coupon being useless unless prices change.

 

Options contracts: Types

 

Options contracts are commonly traded on exchanges such as the Chicago Board Options Exchange (CBOE), one of the largest options marketplaces in the world. This makes them Exchange Traded Derivatives (ETDs). But options contracts can also be traded outside exchanges, over-the-counter, and facilitated by brokerage houses (OTDs)

 

There are two main types of options. An investor can both buy and sell each type:

• Call options (buy call, sell call)
• Put options (buy put, sell put)

 

Call options: expecting price increases

Call options, give their owner the right to buy a financial instrument, at a predetermined price, before or on the expiration date.

The predetermined price (in options jargon), is called the strike price.

To buy a call option though, someone else has to be willing to sell it. Below we outline two examples of the characteristics of buying as well as selling call options.

 

Buying call options

In our example, we will use stocks but the same principles apply to other asset classes that allow options contracts trading.

Here a stock is trading at $50. Our analysis tells us it will probably rise soon.

We buy a call option with:

• Strike price: $55 (only if it reaches $55 can we exercise the option)
• Expiration: 1 month
• Premium (cost): $2 per share
  • Note: With stocks, options contracts have minimum size 100 shares. So the premium displayed on the platform, is multiplied by 100 to find the full cost.

Potential outcomes:

If the stock touches and rises above the strike price of $55, say to $65, we can exercise our option to buy it at $55. That’s a $10 difference. After subtracting the $2 premium we paid and any other brokerage expenses applicable, our profit would be $8 per share.

If the stock doesn’t rise above the strike price of $55 before the expiry of 1 month, our option will expire worthless, and we lose our $2 per share we paid.

 

From this example: Options contracts Vs owning the shares

If we owned the share, we would be locked in its price tantrums, and lose a lot more than the premium. By locking a small amount (the premium), we take a calculated risk that cushions our decisions irrespective of the outcome.

 

Why buy call options?

• You believe the asset’s price will go up.
• You want to control more shares with less money.
• You want to limit your risk (to the premium paid).

 

Selling (writing) call options

A buyer of a call option needs a counterpart. Someone that owns the assets (not necessarily though, we will explain “naked options” later), and doesn’t think the price will rise much from where it sits.

When selling a call, an agreement binds the seller to sell shares at the strike price, if the buyer decides to exercise the option.

This is also called writing a call.

 

Suppose you already own the 100 shares of the example above. The stock is trading at $50. You sell a call option to the buyer above, with a $55 strike price. You also collect $2 per share.

If the stock stays below $55, the option expires worthless for the buyer. What this means for you? You keep your shares and the $2 premium you collected early in the trade.

If the stock rises above $55, say to $65, you are bound to sell your shares at $55. You don’t pocket the $10 difference because you don’t own them anymore (you kind of pawned them). But you keep the premium.

Note: If you bought these 100 shares lower than $55, you gain from there too.

 

Covered call Vs Naked call

Since you already own the stocks, this is called a covered call. But what if you didn’t own them?

You can still sell a call option, but you are not covered. This is called a naked call.

With naked calls, if the price jumps, you are obliged to buy at the higher price, and immediately sell at the lower price to settle your promise.

Example: Imagine a scenario where you collect a down-payment for a TV you don’t own that is worth $200. Your expected delivery is end of the month. If the price at expiry jumps to $300, since you don’t own the TV, you must buy it for $300 and sell it immediately for $200.

Sounds counter intuitive right? Well, this is the risk of trading naked options.

 

Why sell call options?

• To generate extra income from stocks you already own.
• When you think the stock won’t rise much.
• To slightly reduce risk through premium income.

 

Your upside is limited to the premium. If the stock jumps to $80, you must sell at $55 so capital gains for you (except if you bought lower than the $55)

 

 

Put Options: Expecting price decreases

 

Put options, give their owner the right to sell a financial instrument, at a predetermined price, before or on the expiration date.

The predetermined price is called the strike price.

To buy a put option though, someone else has to be willing to sell it. Like the examples with call options above, below we outline two examples of the characteristics of buying as well as selling put options.

 

Example: Buying put options

Here again a stock is trading at $50. Our analysis tells us it will probably drop soon.

We buy a put option with:

• Strike price: $45 (only if it reaches the strike price can we exercise the option)
• Expiration: 1 month
• Premium (cost): $2 per share

 

Potential outcomes:

If the stock falls to $35, we can still sell it at $45. That’s a $10 difference. After subtracting the $2 premium and any other applicable expenses, our profit would be $8 per share.

If the stock stays above $45 by the expiration of 1 month, the option expires worthless and we lose the $2 premium.

 

Why buy put options?

• You believe the stock will fall.
• You want to profit from a decline.
• You want to protect shares you already own.

 

Selling (writing) put options

A buyer of a put option also needs a counterpart. Someone that doesn’t think the price will decrease.

When we sell a put option, we agree to buy shares at the strike price if the buyer decides to exercise the option.

Example: Selling a put

The stock is trading at $50 like above. We sell a put with a $45 strike and collect $3 per share.

If the stock stays above $45:

• We keep the $3 premium and we do not buy the stock.

If the stock falls to $35:

• We must buy it at $45. We keep the $3 premium, but our shares are worth less than you paid.

 

Here’s another example that doesn’t involve stocks. A house costs $400,000. You tell the seller:

“I’ll promise to buy it for $380,000 if the price drops. Pay me $3,000 for making that promise.”

• If the house never drops like you expected, you keep the $3,000.
• If the house falls to $340,000 because you were wrong. you must buy it at $380,000.

 

Meaning: You get paid for being willing to buy something at a discount. If the value crashes, you’re stuck paying much more than its current worth.

 

Why sell puts?

• You want to buy a stock at a lower price.
• You want to earn premium income.
• You believe the stock will stay above the strike price.
• However, if the stock crashes to $10, you still must buy at $45.

 

 

Why traders choose options contracts?

Traders and investors use options contracts for the same reasons they choose any derivative product.

 

To capitalize on price moves (speculation)

Like in the examples above, options contracts align with specific expectations or personalized analysis.

• Buying calls if expecting growth (and vice versa)
• Buying puts if expecting decline (and vice versa)

 

To reduce exposure and risk (hedge)

Like we saw in our definition above, options can act like insurance.

We pay a smaller premium that allows us to take action when required. Like buying a put to protect stocks we already own in case they fall (either due to volatility, or company announcements, or other).

Even large institutions and funds use options for protection. Major financial indexes like the S&P 500 often have options tied to them, allowing investors to hedge entire portfolios.

 

The premium is a third reason, that futures contracts don’t offer (income)

Investors generate regular income by selling options.

Like with selling covered calls monthly, on long-term holdings. According to popular opinion, selling options contracts has more chances of success than buying them.

 

Are options contracts risky?

Options contracts have a mixed reputation. Some traders see options as risky, complicated and similar to gambling, while others see them as smart risk management tools and income generators on long term holdings.

All traded financial products and instruments pose risk, especially if guesses are uneducated and accidental. Beginner traders especially should not be looking into over complex instruments, until they have a good grasp of the environment, the system that controls them, and doubled down on more straight forward trading applications.

At the same time, all the good reasons for trading options contracts are also valid, and with discipline and time, they can prove very helpful in sizing and protecting portfolios.

 

_________________________

 

allFX-Consult is a performance trainer for client facing teams in our space. Our Capital Markets training is specifically designed to bridge the gaps let by inconsistent past training or no training at all in many cases.

We aim for 100% interaction, minimum to zero slide reading, and constant verbal exercises that aim to inspire confidence.

Capital Markets workshops are delivered worldwide, along with the other 3 modules in our Growth Training suite that include Mindset (understanding relationships and latest communication practices), Performance (frameworks, objection handling) and Industry Essentials (specific to the online trading industry).

We love interacting with teams. Its what we do since 2014. Contact us for a discreet conversation to elevate communication with leads and clients.

 

Futures contracts are agreements between two parties to:

• buy or sell an asset
• at a specific price
• on a specific date in the future

 

When we say buy or sell an asset, we refer to any financial asset like oil, gold, wheat, coffee, indices like the S&P 500 or the Dow, cryptocurrencies and other similar financial products.

 

What we should take from this, is that the settlement price is agreed today, but the actual settlement is yet to come. To grasp the idea better, think of a “now” moment, a spot transaction where settlement is technically T+2 days, and settled immediately in cash. Futures contracts don’t settle in the “now” moment in cash, but at a later day (in 1 month, 3 months, 6 months etc)

 

Why do futures contracts exist?

Futures contracts are derivative products. As such and like all derivative products, they are mainly used for two reasons. To hedge / reduce exposure, and of course to ride price waves and capitalize on their movements.

 

To reduce exposure and risk (hedge)

Imagine you are a farmer growing wheat. You are worried that the price of wheat might fall by the time you harvest it in six months, due to geopolitical uncertainties.

To protect yourself from this, you sign a futures contract to sell your wheat at $6 per bushel in six months.

• If you are correct and prices fall to $4, you’ve protected yourself against the drop.
• If prices rise to $8, you might think you missed the extra profit, but you avoided the opposite scenario, reducing your exposure.

Bottom line is that although the extra profit is welcome, the price agreed when the contract was signed was an acceptable price, based on the costs and margins calculated at the time.

 

To capitalize on price moves (speculation)

Some traders don’t grow wheat or use oil. They simply want to predict whether prices will go up or down and use the supply and demand dynamics created by those who do want to settle, to capitalize on the price moves.

• If they guess correctly, they make money.
• If they guess wrong, they lose money.

 

This summarizes the concept of speculation. Important to note, that speculation is still a guess, and at its best form is an educated guess. Through fundamental and technical analysis, traders bring themselves as close to a correct prediction as they can possibly be. Anything else, like wild guesses, hunches, and wild goose chases, fall in the realm of gambling.

 

How do futures markets work?

Futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME).

In a quick summary, here’s how the process works:

1. Buyers and sellers agree on a futures price.
2. The exchange acts as a middleman to make sure both sides follow the rules.
3. Both sides deposit collateral money, also known as margin to lock the deal in.
4. Profits and losses are calculated daily (mark-to-market).
5. On the settlement date, the contract is closed or settled.

Most futures contracts are never used to actually deliver goods. Instead, traders close their positions before the contract expires.

 

Futures: Key terms

All futures contracts require a buyer and a seller.

Long Position

• If you buy a futures contract, you are said to go long.
• You expect the price to go up.

Short Position

• If you sell a futures contract, you go short.
• You expect the price to go down.

 

All futures contracts also require a collateral and a settlement date/type.

Margin is a small deposit required to open the contract.

• Initial margin is the amount required to open a position.
• Maintenance margin is he minimum amount that must stay in your account.

 

Note: If your account falls below the maintenance margin, the broker house will send you a margin call (usually on the position in the system), that alerts you to add more money. If not, the position will be closed by the system.

Settlement is how futures contracts end.

• Physical settlement when the actual asset is delivered (like oil or wheat).
• Cash settlement when no asset is delivered. Instead, profits and losses are paid in cash.

 

Calculation examples (including two examples, one with and one without cost of carry)

 

Cash settlement: Simple example using gold futures. Hypothetical numbers:

• Current gold futures price = $2,000 per ounce
• Contract size = 100 ounces
• Total contract value = Futures price x contract size (2,000 x 100 = 200,000)
• Margin requirements = 5%
• Margin = 200,000 x 5% = 10,000
• To open a 200,000 value contract, you only need 10,000
  • Note: To find the leverage in this example: 200,000 / 10,000 = 20
  • So this contract is leveraged 20:1 or 20 times.

 

If you buy the contract and:

• price rises to 2,050, you profit 50 x 100 = 5,000. That’s a 50% return on your 10,000.
• Price drops to 1,950, you lose 50 x 100 = 5,000. Also 50% on your 10,000.

 

Physical settlement: Example using gold futures contracts with carry costs

We want to estimate a 3-month futures price based on today’s spot price and carry costs (interest + storage). We’ll use the cost-of-carry model.

• Spot price of gold (price today) ≈ $5,007.70 per ounce.
• For commodities, a basic cost-of-carry pricing formula is: F₀ = S₀ x e^{(r + c) x T}

• Where:
• F₀ = theoretical futures price
• S₀ = current spot price
• e = 2.71828 (the base of natural logarithms)
• r = annual risk-free interest rate
• c = annual storage cost (as a % of spot price)
• T = time to expiration (in years)
• Assumptions for the example
  • Spot price of gold = $5,007.70/oz
  • Time to contract expiry = 3 months (0.25 years)
  • Risk-free interest rate = 5% per year (typical U.S. short rate)
  • Storage cost = 0.5% per year (approx. for bullion storage)
  • Convenience yield = 0 (for simplicity here)

Calculation:

Add interest + storage rates

• Interest (5%) + storage (0.5%) = 5.5% total annual cost
• r + c = 0.05 + 0.005 = 0.055

Multiply by time to maturity

• (r + c) x T = 0.055 x 0,25 = 0.01375

Use the futures pricing formula

• F₀ = S₀ x e^{(r + c) x T} = 5,007.70 x e⁰¹³⁷⁵
  • Use a calculator to find e⁰¹³⁷⁵ = 1.01384
• F₀ = 5,007.70 x 1.01384 = 5,076.93

 

What this means is that the theoretical futures price for a 3-month gold contract is about $5,076.93 per ounce. Holding (or carrying) gold for 3 months, including interest and storage, would cost around $69.23 per ounce above the spot price today.

 

Why futures contracts matter in our day to day

So many examples we could list like farmers locking in prices, or the airline example above locking fuel prices to protect against uncertainty. Companies dealing with international markets can manage intense currency fluctuations and so on.

At the same time, futures prices are direct reflections of expectations about the markets. They reflect what traders believe a commodity (or other) will cost months from now.

 

Are futures contracts risky?

Absolutely. All traded financial products and instruments pose risk, especially if guesses are uneducated and accidental. Beginners especially should look into what every position is telling them in terms of leverage, margin, risk tolerance and appetite.

Large profits can amass quickly because of leverage, but so can losses. Accounts can be wiped out in a single move, so protecting your asset with knowledge is of utmost importance. Use risk limits, stop-loss and take-profit orders and size the positions carefully. And these, outside the regular check of fundamentals and technicals to secure proper entry and exit levels.

 

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.

 

_________________________

 

allFX-Consult is a performance trainer for client facing teams in our space. Our Capital Markets training is specifically designed to bridge the gaps let by inconsistent past training or no training at all in many cases.

We aim for 100% interaction, minimum to zero slide reading, and constant verbal exercises that aim to inspire confidence.

Capital Markets workshops are delivered worldwide, along with the other 3 modules in our Growth Training suite that include Mindset (understanding relationships and latest communication practices), Performance (frameworks, objection handling) and Industry Essentials (specific to the online trading industry).

We love interacting with teams. Its what we do since 2014. Contact us for a discreet conversation to elevate communication with leads and clients.

 

Most beginner traders and investors, come across the term “derivatives” quite early in their journey. When it comes up, the complexity and variations of derivatives might misrepresent what they can actually achieve and in what context. Some see derivatives as an opportunity, others not so much.

 

But there’s nothing scary about derivatives. If anything, they are trading and investing products designed to mitigate risk, if used in the proper context. And even when not used in the context of risk management and the choice is to use them to speculate, trading platforms have the necessary features to surround positions with as much risk mitigation as required by the trader.

 

Derivatives simply put, are financial tools that help people manage risk, protect their money, or try to make a profit.

 

What are derivatives?

Derivatives are financial instruments whose value is derived (taken from) from something else. In the trading and investing jargon, that “something else” is called the underlying asset.

 

Imagine you and your friend making a bet about whether it will snow tomorrow. The value of your bet depends on the weather (the underlying asset). If it snows, one person wins. If it doesn’t, the other person wins. Your bet’s value comes from (and is fully dependent on) the weather.

 

That’s similar to how derivatives work in the financial markets. The underlying asset is a financial market and can be:

• Stocks (like shares of Apple)
• Commodities (like oil, gold, or wheat)
• Currencies (like the U.S. dollar or euro)
• Interest rates
• Market indices (like the S&P 500)

 

Important: Derivatives themselves do not have value on their own. The value depends entirely on the price of the underlying asset.

 

Why do derivatives exist?

Derivatives are mainly used for two big reasons and we’ll dig deeper into each of them.

• To manage risk (called hedging)
• To try to make a profit (called speculation)

 

Managing risk (hedging)

Imagine you are a farmer growing commodities like corn, barley, wheat, coffee or other. You know that in six months, you will harvest your commodity and immediately sell it. But what if commodity prices drop before then? You could lose a good amount of money.

To protect yourself, you could make an agreement with a willing buyer today, to sell your commodity at a fixed price in the future. As we’ll see later, a futures contract creates an obligation to buy and sell for the parties who enter the contract. So even if commodity prices fall, you are protected.

This contract, the futures contract, is a type of derivative. In itself is meaningless, but with the price of its underlying (the commodity), it’s a valuable active product.

Simply put, derivatives can act like insurance against price changes.

 

Speculation (trying to make a profit)

In the case of commodities, most trading in the futures market, has no intention of owning the underlying. Rather, the goal is to ride the waves of supply and demand created by those with intention to settle, and profit by guessing where the prices will go next.

Same goes with other asset classes as well. With equities for instance, a trader might not want to own shares, but rather ride the waves of their price. If someone thinks shares of Tesla, Inc. will go up next month, they can buy a derivative that increases in value if Tesla’s stock price rises.

If they are right, they can profit the difference from the initial purchase price, minus the closing price and any broker commissions/expenses. If they are wrong, they can lose money *all trading products are risky and carry a possibility of a loss.

 

Common types of derivatives

There are four main types of derivatives, any trader/investor should know about:

• Futures (like the example above)
• Forwards
• Options
• Swaps

 

We’ll explore each one in simple terms below.

 

Derivatives: Futures

Futures contracts are agreements to buy or sell something at a specific price on a specific future date.

Imagine that today oil costs $70 per barrel. You believe that in three months, oil will cost $80 for fundamental reasons like OPEC’s decision on daily barrel output. You can sign a futures contract to buy oil at $70 in three months.

• If oil goes up to $80, you profit the difference (minus expenses).
• If oil drops to $60, you lose your investment.

 

Futures are standardized contracts and they are usually traded on exchanges. This makes them organized and regulated.

Last but not least, it’s important to note that entering a futures contract creates an obligation for settlement. A buyer is obliged to buy at expiry, and a seller is obliged to sell, irrespective of profits or losses.

 

Derivatives: Forwards

A forward contract is very similar to a futures contract. It is also an agreement to buy or sell something at a future date for a set price.

The main differences?

• Forwards are private agreements between two parties. Therefore, credit or default risk is high, with no intermediation for honouring the contract.
• They are not traded on public exchanges, therefore they not organized or regulated.
• They can be customized, since they are not standardized according to the rules of an exchange.

For example, a bakery and a wheat farmer might agree today on a price for wheat to be delivered in six months. This protects both sides from price changes as long as they honour their contract. Legal battles can, and do take place, but the process is costly and time consuming.

 

Derivatives: Options

Options contracts give traders the right, but not the obligation, to buy or sell something at a specific price before a certain date.

That phrase “not the obligation” is very important because it negates the obligation that a futures contract creates.

There are two main types of options:

• Call option. Gives the owner the right to buy
• Put option. Gives the owner the right to sell

 

Let’s say shares of Microsoft Corporation are trading at $300. You believe the price will go up. You buy a call option that allows you to buy the stock at $300 within the next month.

• If the price rises to $350, you can buy at $300 and benefit by selling immediately at 350.
• If the price falls to $250, you don’t have to buy since you are not obliged to. You can simply let the option expire.

There are 4 ways to actually utilize the full benefit of options contracts, by buying or selling a call, and by buying or selling a put.

Options contracts are often used as protection. For example, an investor who owns stock might buy a put option to protect against a big drop in price.

 

Derivatives: Swaps

A swap is an agreement between two parties to exchange financial payments. A usual swap agreement takes place to swap payments on interest loans. So the most common type is an interest rate swap.

Here’s an example:

• Company A has a loan with a fixed interest rate.
• Company B has a loan with a variable interest rate.

If Company A thinks variable rates will go down, and Company B prefers stable payments, they can swap interest payments.

They are not exchanging the loans themselves (the principal). Only the interest payments.

Swaps are typically used by large companies and banks and require a good relationship and trust between the exchanging parties to enter in such contracts.

 

Derivatives: example

Let’s look at a simple example involving airlines.

Airlines use a lot of fuel, right? Fuel prices can go up and down quickly. If fuel prices suddenly rise, airlines can lose a lot of money, given the fuel amounts they go through.

So an airline might use a futures contract to lock in today’s fuel price for future use.

If fuel prices rise later, the airline is protected.
If prices fall, they might miss out on lower prices. But in their view, they gain stability and certainty at a price they are comfortable paying now and into the future.

 

Why are derivatives important?

By definition alone, we can see how derivatives can play a big role within the bigger context of the financial markets. Some important characteristics include (but are not limited to):

 

Risk management

They help companies, farmers, investors, and banks reduce risk. By hedging, everyone is locked in a price they currently feel comfortable with, irrespective of the final outcome of the price.

Price discovery

Due to the sheer volume of traded derivatives, they create the market by showing future expectations about where the price may land. Looking at derivative prices, and comparing them to spot prices, we can hear the markets speaking and we can react accordingly. Think terms like backwardation (when futures price is lower than spot) and a more normalized relationship called contango (when futures price is higher than spot).

Liquidity

Where would the markets be without the liquidity of derivatives? The easy access of buying and selling assets, is heavily dependent on derivatives that make markets anywhere they go.

Flexibility

They allow investors to create strategies that fit their needs, whether they want protection or profit. The risk Vs reward, the ease of access, the velocity by which they move, they all allow for various risk appetites and flexibility with choosing strategies.

 

Are derivatives dangerous?

Absolutely they are. Derivatives are complex financial products and require careful consideration. Since it is a fact that nobody can predict with 100% accuracy what the markets will do next, its important to avoid empty promises of profits, or guaranteed predictions and prophesies.

At the same time, we must recognize that derivatives are tools. Like any tool, they can be used wisely or irresponsibly by traders. For those who use derivatives carefully to reduce risk, they can be very helpful. For speculators, depending on their level of knowledge, they can also prove very cost effective and easy to manage.

For those though, who use them to make risky bets without understanding them, they can lose a lot of money.

During the 2008 financial crisis, complex derivatives connected to housing loans (subprime mortgages) caused serious problems in the global economy. This showed how powerful and risky derivatives can be if not managed properly (both from the buy side as well as the sell side).

 

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.

 

_________________________

 

allFX-Consult is a performance trainer for client facing teams in our space. Our Capital Markets training is specifically designed to bridge the gaps let by inconsistent past training or no training at all in many cases.

We aim for 100% interaction, minimum to zero slide reading, and constant verbal exercises that aim to inspire confidence.

Capital Markets workshops are delivered worldwide, along with the other 3 modules in our Growth Training suite that include Mindset (understanding relationships and latest communication practices), Performance (frameworks, objection handling) and Industry Essentials (specific to the online trading industry).

We love interacting with teams. Its what we do since 2014. Contact us for a discreet conversation to elevate communication with leads and clients.

 

We’ve always tried to give a balanced view when things are not set on stone since at the end of the day, everything is an opinion rather than a fact and if the opinion serves its purpose (educated decisions for the opinionated), then why not?

A discussion between a broker dealer and a client this morning regarding technical vs fundamental analysis piqued our interest and these discussions usually miss a critical part. That is the underlying reasons that drive the prices we see on charts, rather than the analysis itself. That’s because those reasons are liquid, yet the analysis process is always the same.

Most price charts available to the retail investor, show price, time, and volume. Indicators are layered on top or oscillate below. And although technical view is extremely important, there are structural elements of how markets function that influence price behaviour long before it becomes visible on a chart.

 

Price is the final output, not the input

A popular grounding approach to trading, is that no one can predict consistently and with 100% accuracy what the markets will do. Multiple reasons to outline here, but we’ll only mention the human element which in our view, is a catalyst when it comes to unpredictability. People operate via emotions and tend to act on those, even if the decision is what should be.

Evidently, a chart shows the result of trading, not the process. Before any candle forms, limit orders are placed or removed, liquidity gets deep or shallow, or limitations force certain participants to act (some when they should, some when they shouldn’t, more on this below).

By the time price behaviour actually updates and materializes on charts, these processes have already occurred.

So professional focus tends to search for the conditions that must exist for price to move the way it does.

 

Price behaviour: Inventory and positioning (not sentiment)

Retail story telling often relies on “bullish” or “bearish” sentiments. Professionals, focus instead on who is already positioned.

Positioning refers to net exposure held by participants, a concentration of similar bets. When it gets concentrated, it gets crowded and we’ve heard a great statement by a chief dealer on this who said “moves often happen on position adjustments, not when they were initiated in the first place”.

 

Price behaviour: who is forced to trade (and who isn’t)

As mentioned above, limitations force certain participants to act. These limitations depending on the asset class (if asset-specific), can be margin requirements, redemptions, rebalancing schedules, compliance constraints, expiring contracts and so on.

What this means is that price is again irrelevant. Action will take place nonetheless, and it would be very challenging for a chart to predict and show these in real time, for retail traders to base their decisions on. Other than taking actions regardless of price, these participants create pressure without expressing directional opinion.

Therefore again, charts will show the result of the forced act, not the educated decision to position.

 

Price behaviour: Liquidity conditions, maybe not volume

Another important point professionals look for is liquidity conditions. The order book depth is a good starting point, with the size available at each price level. Crowded or thin liquidity can speak wonders, much more than volume could potentially do. Any volatility spikes without reason (new information or other), fast moves on small flows, or sudden price gaps are a good indicator of thin liquidity.

 

Price behaviour: Time based constraints

Another important point candles don’t explain, is time constraints related to time-in-force orders (TIF), expiration dates, settlement cycles, roll periods, reporting deadlines, funding resets etc.

The price shown on a chart (e.g., a 1-minute candlestick) is an aggregation of all trades that occurred during that minute. Individual trade prices, which might have varied due to latency or TIF constraints, are averaged or represented by the high/low/open/close of that candle, masking the micro-level price movements that occur in milliseconds.

When thinking TIF orders, you think day order, good-til-cancelled (GTC), fill-or-kill (FOK), immediate-or-cancel (IOC): Any portion of the order that can be filled immediately is, and the remainder is cancelled.

The effects of these constraints are primarily related to the difference between the intended price and the actual executed price (known as slippage). These factors influence the actual transaction price before it is ultimately recorded and displayed on a chart.

 

Price behaviour: Funding rates, carry, and holding pressure

Funding, carry, and holding pressure create temporary price distortions and influence the spot and futures price relationship, through real-time supply and demand dynamics and financing costs. These pressures are a factor in the actual execution price, which is the data point that eventually forms the chart we analyze.

Funding rates are periodic payments between long and short position holders. The price adjustments happen within the market’s live order flow. When arbitrageurs (as an example) act on price discrepancies, they cause moves to help prices converge before they even appear on the chart.

The cost of carry includes interest costs for financing the positions, storage/insurance costs for physical commodities, subtracting any income generated by dividends or the convenience yield. Same with funding, traders act on discrepancies, adjusting the prices before appearing on a chart.

When a large volume of an asset is held by a few participants it creates potential for significant price fluctuations when those holders decide to trade. Buying or selling pressure drives prices up or down respectively. Think of a large, sudden order from a major holder clearing multiple price levels in the order book almost instantly. Maybe high-speed algorithms can react to such an event, but general market participants will only act after charts record it.

 

Using volatility as a behaviour alternator, and not how it “plots”.

It’s true that volatility is “plotted” through technical indicators, but this only reflects what has already happened. Volatility is often described as the “fear index”, it directly triggers psychological biases, drives impulsive decisions and overreactions to “noise”.

Technical indicators that “plot” volatility are primarily historical tools that summarize past behaviour. They tell you the market was volatile and lag in nature.

How to act on this? As an example, professionals in volatile times reduce position sizes and readjust to stay “in” the market. They also exploit irrational discounts, and purchase high quality assets when others dump them.

So think volatility plots as the “what”, and volatility behaviour as the “why”. Indicators Vs sentiment analysis, lagging Vs anticipatory data reactions.

 

Look at asset correlations under stress, not in smooth sailing

Asset correlations are very important, some might say the cornerstone of diversification. But unless the correlations are structural, something is bound to break during volatile conditions. Where historically asset relationships spoke the same language, under stress one speaks English and the other Finnish.

Temporary asset correlations behave differently, while structural ones reassert themselves (especially if they disconnected for a minute). Charts average these events and speak after the fact.

 

Who is providing liquidity right now

Are market makers active or defensive? Any changes in quoting behaviour? What about the spreads?

When liquidity providers become defensive, price becomes sensitive, there is an acceleration in fluctuations, and technical levels might lose relevance.

 

The difference between trading an instrument and trading a system

An instrument exists inside a clearing system, a margin system, a regulatory system and a funding system. Prices on charts might reflect changes and shifts, but don’t necessarily explain them. As rules change, as capital requirements change, these changes affect behaviour.

A lot of this information stays away from retail charts because it is contextual, qualitative and requires interpretation. Charts are great in providing a visual representation of what happened. But they are limited at showing everything else.

 

Final thoughts

Paying attention to structure and behaviour defines professional traders. Answering questions like who is acting, who is waiting, what limits the behaviour and where pressure accumulates, these are all forces that shape markets long before they appear in the candles of a chart.

 

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.

 

_________________________

 

allFX-Consult is a performance trainer for client facing teams in our space. Our Capital Markets training is specifically designed to bridge the gaps let by inconsistent past training or no training at all in many cases.

We aim for 100% interaction, minimum to zero slide reading, and constant verbal exercises that aim to inspire confidence.

Capital Markets workshops are delivered worldwide, along with the other 3 modules in our Growth Training suite that include Mindset (understanding relationships and latest communication practices), Performance (frameworks, objection handling) and Industry Essentials (specific to the online trading industry).

We love interacting with teams. Its what we do since 2014. Contact us for a discreet conversation to elevate communication with leads and clients.

Portfolio diversification, is probably the first (sometimes only) advice investors receive, to calibrate their thoughts towards risk mitigation.

The concept is sound (although not flawless), and relates to the chaotic behaviour of markets during different economic cycles, and how placing all your eggs in one basket can lock a portfolio in situations difficult to manage.

At the same time, when certain asset classes fall, others rise, allowing for cushions against drawdowns and a more balanced approach to investments.

A big part of diversification, falls in understanding how asset classes behave with one another, in different environments, to know what to expect. In other words, knowing the asset correlations.

 

What is correlation and what does it actually measure?

Correlation measures how similar, different assets move at any given time. Mathematically, they are displayed using binary numbering from -1 to 0 to 1.

Here’s how. A correlation of:

• +1 means two variables move perfectly together
• 0 means no measurable linear relationship
• –1 means they move in exact opposite directions

 

Two assets can show high correlation simply because they are reacting to the same external factor, or they are traded by the same participants, or they are funded the same way. The problem is that none of these reasons guarantee the relationship (correlation) will persist.

 

Therefore, correlation measures co-movement, but not causation. Not knowing what triggers the correlation, beats diversification principles at their own court because correlation is backward-looking, it is time-window dependent (more on this below), and most importantly it does not explain why assets move together.

 

Correlations are reliable until they aren’t. For that we need to understand the two correlation types. Structural and temporary. These are two concepts that are often commingled, but behave very differently under stress.

 

Structural correlations

These types of correlations are present by default. The “mechanics” behind them are anchoring the relationships allowing them to persist. Think of a stock index future and its underlying cash index. Think of a bond price and its yield, or a currency pair and its interest rate differential, or an ETF and the basket it must physically track.

 

There is no changing of the relationship between a bond price and its yield, because mechanically they are inversely connected. The bond has a fixed coupon (interest payment), so a lowering of the price will always raise its yield and vice versa. A cash index is meant to track the behaviour of its futures counterpart, so they will always move together because they were built to do so.

 

These designed relationships that persist across different economic environments, can only break if the structure (their design) changes, and even if there are periods of short-term dislocations, they will reassert themselves.

 

Temporary asset correlations

These types of asset correlations are not designed or structured in any way. They are organically caused by the prevailing conditions and sentiment, and they are present because they share these conditions. They are created and driven by risk on / risk off behaviour, central bank policies, positioning, leverage, narratives or economic environments (inflationary / deflationary).

 

Think of stocks and crypto moving together, or tech stocks and long duration bonds, or commodities and emerging markets equities, or different asset classes reacting the same way to monetary policies.

Everything mentioned above is situational and heavily depend on the current environment. They can appear strong and stable one day, and break abruptly the next. These are not embedded or engineered relationships like the structural ones.

 

Why temporary correlations feel so convincing

Temporary correlations can create a false sense of permanence. They often coincide with strong trends, clear narratives and high confidence environments that seem obvious even to the trained eye. Correctly so though, but the trained eye knows better than to take numbers -1, 0 and 1 for granted, without looking at the bigger picture.

 

The bigger picture involves economies that move in cycles, and these cycles have short-term debt cycles that are embedded in long-term debt cycles, external and internal partnerships / conflicts, all of which exist within developed or under-developed countries as well. A correlation number speaks, but not loud enough.

 

Temporary asset correlations may feel reliable because when many participants hold similar trades, price movements align, so they tend to reinforce their positioning. Also deleveraging, forces multiple assets to move together amplifying them through leverage. Lastly, narratives create coherence even when mechanics are absent, explaining the relationships by stories.

 

How asset correlations break

Asset correlations often increase during crises, then collapse afterward. Not set in stone, but there are two clearly defined reasonings to how asset correlations break.

 

An oversimplified example would be to think how markets move together under monetary policy expectations. Then inflation suddenly becomes the dominant constraint and assets once positively correlated begin diverging.

 

So the dominant force that drove the relationship, changed.

 

In the second reasoning we need to think stress scenarios where participants sell what they can, but not necessarily what they should. All investors try to reason and time their decisions, but emotional drivers are another factor of erratic behaviour. This shared activity spikes asset correlations toward 1 and structural differences are temporarily ignored.

 

So liquidity overrode logic, evidently changing the relationship.

 

The most overused case example: The relationship between stocks and bonds

For decades, stocks and bonds often showed negative correlation. How?

• Growth weakens; bonds rally due to their safer nature
• Growth strengthens; stocks rally due to their riskier but rewarding nature

This relationship felt structural, and gave rise to portfolio allocation percentages like the 60 / 40 (60% on stocks, 40% on bonds to maintain balance). But the relationship was anything but structural. It depended on stable inflation, central bank credibility through predictable policy reactions.

When inflation returned as a constraint in multiple occasions, both assets fell together and the correlation flipped. The structure of bonds did not change. The dominant macro variable did.

 

Asset correlations vs. dependency

Asset correlations do not capture the situation dependence. It captures linear movement, but markets often exhibit non-linear dependency. This is highly related to whether markets are calm or stressed. They might uncorrelated during calm times, then correlate during stressful times, and then decouple again. This is not a statistical error but a reflection of conditional behaviour.

Markets behave differently when volatility rises, when funding tightens, when margins increase, or when risk limits are hit. These important rolling windows are not captured in asset correlations that say more about recent conditions, than how strong and enduring the relationship is.

 

Structural relationships that survive stress

Structural asset correlations tend to reassert themselves even after breakdowns. As mentioned in their definition above, they are designed to behave in a mechanical way. Futures prices converge to meet spot at expiration. Irrespective of contango or backwardation conditions, the design is convergence. Other examples include arbitrage relationships enforced by balance sheets and hedged instruments tied by contractual obligations.

In contrast temporary asset correlations, often don’t return once broken.

This explains why diversification sometimes fails and a wider narrative should always accompany a narrow one. It explains why “safe” bets on relations reverse and why sometimes historical asset correlations disappoint. As investors we constantly interpret, we don’t predict.

 

How should we think of asset correlations?

Instead of asking whether two assets are correlated, a more informative question is what mechanism forces this relationship to exist in the first place.

Find the answer in between by examining the relationship’s design and if it follows the mechanical approach (by default, legal obligation, settlement, arbitrage), it makes it structural and hard to break.

If the answer is more abstract and relies on rolling windows (policy decisions, narratives, risk sentiment, positioning, economic environments), it makes it temporary and prone to break.

 

Asset correlations is a description. They don’t provide an explanation. Understanding why assets move together is more durable than measuring how much they have done so in the past.

 

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.

 

_________________________

 

allFX-Consult is a performance trainer for client facing teams in our space. Our Capital Markets training is specifically designed to bridge the gaps let by inconsistent past training or no training at all in many cases.

We aim for 100% interaction, minimum to zero slide reading, and constant verbal exercises that aim to inspire confidence.

Capital Markets workshops are delivered worldwide, along with the other 3 modules in our Growth Training suite that include Mindset (understanding relationships and latest communication practices), Performance (frameworks, objection handling) and Industry Essentials (specific to the online trading industry).

We love interacting with teams. Its what we do since 2014. Contact us for a discreet conversation to elevate communication with leads and clients.