What is a Flow Derivative
A flow derivative is a securitized product that aims to provide maximum leverage to profit from small movements in the market value of the underlying. Flow derivatives are based off the value of currencies that are associated with a set of assets. Some popular flow derivatives include vanilla options, leveraged synthetic spot positions (WAVE XXLs) and synthetic structured forwards (such as bonus certificates). Flow derivatives are traded on exchanges or other electronic platforms.
BREAKING DOWN Flow Derivative
Flow derivatives are usually designed to allow investors to make directional bets on exchange rates between currencies or on whole market directions. Flow derivatives can mimic the payout trends of over-the-counter (OTC) products while offering the ease and transparency of being exchange traded. Because flow derivatives are traded on electronic platforms, it is easy for traders to access real-time prices and place trades automatically.
Flow Derivatives and the World of Synthetics
Flow derivatives are part of the world of synthetics. These are products that are designed to simplify trading and make directional or trend-driven trading easier. Flow derivatives do this by combining the functions of two or more trades into one product. For example, a synthetic structured forward can combine a long call option and a short put option into a single product with a customized time period. The real-time nature of synthetics can be problematic when a trader is wrong on the directional trade, or right but entering the trade at the wrong time. This is because the cash/futures positions in a flow derivative lose money in real time rather than at a settlement date in the future.
The Components of Flow Derivatives
Flow derivatives trade in and of themselves, but their components are what drive the relationship to the ultimate underlying assets. For example, the WAVE XXLs have been called perpetual futures in that they have no set maturity and a built-in stop-loss feature. WAVE XXL calls are flow derivatives that allow bullish traders to make a leveraged bet on increases in the underlying, containing the aforementioned stop-loss. The opposite product for a bearish trader is a WAVE XXL put that positions itself to profit from a drop in the underlying, again with a stop-loss. The leverage for both is built right into the product and can take a 10% increase in the underlying and multiply it several times. Most important to traders, these products are much more tradable, meaning easier to enter and exit, than setting up and monitoring a similar position of their own.