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Derivatives are investment instruments that come with plenty of upside if you make the right call.
Investors often use these assets for hedging, speculation, or to lock the price of an asset they want to buy later.
But if you make the wrong call, derivatives can come with potentially unlimited downside. As such, they’re often heralded as advanced instruments best suited for expert investors with a keen eye (and deep pockets).
What is a Derivative?
Simply put, derivatives are securities and contracts that derive their value from an underlying asset.
In the past, this primarily included commodities like crops, meat, and crude oil. Today, the derivatives market is comprised of both material and immaterial items, such as stocks and bonds, currency, and precious metals.
You can buy two classes of derivatives:
- Lock products, such as swaps, futures, and forwards, bind the respective parties to the terms of the contract until expiration. If you sell the contract before then, the buyer must adhere to the terms, instead.
- Option products, like stock options, offer the holder (buyer) the right, but not the obligation, to act. However, the seller (writer) must uphold their end of the bargain.
Note that some lock products – notably futures – promise to deliver physical goods at a future date.
Others, like options, permit investors to profit off market fluctuations by trading the underlying asset at an advantageous price. But most derivatives come with an option to settle the debt in cash instead of material goods.
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Snapshot: Financial Derivatives Pros and Cons
- Leveraged instruments can net greater gains
- Increased flexibility over underlying securities
- Limits exposure to (and hedges against) some kinds of risk
- Businesses and investors can lock in prices now
- Contributes to portfolio diversification
- Complex to understand and trade
- Potentially unlimited downside
- Some derivatives are less liquid than their underlying investments
- Not all brokers deal in derivatives or all types of derivatives
- Lack of intrinsic value
- Sensitive to fluctuations in supply and demand, interest rates, and expiration dates
Understanding Derivatives in Finance
Derivatives are considered leveraged financial instruments, as brokers allow investors to lay down a portion of the contract’s cost before trading. While this boosts an investor’s potential gains, it also gives way to literally unlimited losses on a bad call.
Still, some investors consider the upsides worth the risk.
Many – such as institutional investors and large businesses – use derivatives to hedge against volatility and uncertainty.
For instance, a business that trades internationally might take out a forex option to guard against currency fluctuations.
Additionally, businesses who have a stake in an industry may invest in derivative contracts to lock a commodity’s price.
For example, if a mining company opens a new iron mine, a steel smelter might buy one million dollars’ worth of iron at current prices.
Then, when the smelter’s order is filled, they’ll receive their order at the stated price, rather than current market value.
Others use derivatives for speculation, wherein they assume risk with the expectation of profiting off price fluctuations.
One example is when investors buy copper futures with the intention of selling them when the price of copper rises later.
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Where Do You Trade Derivatives?
Derivatives trade in a variety of forums. Where they’re traded determines how (and by whom) they’re regulated.
For instance, most derivatives trade on exchanges. In the United States, these markets are regulated by bodies such as the Securities and Exchange Commission, the National Futures Association, and the Commodity Futures Trading Commission.
But some also trade OTC, or over the counter. These trades occur between online brokers, banks, and investors. As such, they tend to be less regulated, which injects additional risk into the contracts.
For instance, while banks must follow financial regulations, individual investors don’t, meaning that private contracts run a higher risk of default.
Types of Derivatives
Derivatives come in many different flavors. We’re going to cover the main four here.
Future contracts, or futures, are financial contracts that require both the buyer and seller to act on a future date.
The buyer must purchase an asset at a set price, while the seller must provide the asset at the same price.
Regulatory practices demand that trades standardize their contracts to detail:
- The quantity of asset to be delivered
- The price of the underlying asset
- The expiration date of the contract
Conforming to these conditions makes trading futures on regulated exchanges easier. Moreover, it provides legitimacy to futures contracts, as the buyers and sellers must fulfill their side of the bargain regardless of current market conditions.
Forward contracts, or forwards, are futures that trade OTC instead of on regulated exchanges. This allows buyers and sellers to customize their contracts, such as by altering the terms, size, and settlement process.
That said, forwards carry more inherent risk, as either party could renege on their side of the bargain.
Options differ from futures and forwards in that they give investors the right, but not the obligation, to purchase assets upon expiration.
Moreover, many brokers offer options on regular accounts, whereas many brokers don’t deal in more “advanced” derivatives.
Commonly, you’ll see options dealing in stocks (you’ve probably heard of “stock options”), with each contract representing 100 shares of stock. But options may apply to any asset, including precious metals, cattle, energy, and even other derivatives.
You can buy and sell two “types” of options contracts:
- A call option gives the buyer the right to buy a security at a set price on or before a specified date.
- If you buy a call option, you’re taking a potential long position.
- If you sell a call option, you’re shorting the underlying security.
- A put option gives the buyer the right to sell a security according to the contract’s terms.
- If you buy a put, you’re shorting the underlying security.
- If you sell a put, you’re taking a potential long position.
Note that buyers, or holders, do not have to act on their contract. However, sellers, or writers, must act on their contract if it expires in-the-money.
While details vary based on the specific option, in-the-money broadly means that the contract benefits the buyer.
Investors can also trade interest-rate products by way of derivatives, although the details get a little messy.
Typically, those who deal in swaps do so to avoid interest rate risk, which causes the underlying asset’s price (such as a loan) to change.
Let’s explain swaps with a simple illustration.
Company Aardvark has a high fixed-rate loan of $100,000. They want to switch to a variable rate loan while the market swings low.
But their lender won’t permit the switch due to worries that Company Aardvark won’t make their payment if interest rates skyrocket.
Along comes Company Bombadil. They have a variable-rate loan worth $100,000. They, too, are worried that interest rates are about to soar, and are looking for a fixed-rate loan to protect them from future fluctuations. However, their credit score is just too low to refinance their loan.
So, the two companies write a swap contract. Company Aardvark agrees to make the monthly payment for Company Bombadil for the rest of Bombadil’s loan term. In return, Company Bombadil will cover Company Aardvark’s payments.
The contract cements the agreement in stone, so that if interest rates move opposite one party’s interests, they’re still obligated to pay.
As you can imagine, swaps don’t come without risk – in this case, fluctuating interest rates are the risk.
But many other complex types of swaps exist, too, such as currency exchange rates, loan defaults, and cash flows.
What is a derivative in financial terms?
Derivatives are securities that derive value from their underlying asset. For instance, a stock option is valued based on the price of the underlying stock.
What is a financial derivative with examples?
Derivatives come in many types, such as futures, options, and swaps. One example is a futures contract where a steel company agrees to buy $1 million worth of iron from a mining company six months in the future at current market prices.
What are the main benefits and risks of derivatives?
Derivatives provide several benefits, including buying profitable positions on leverage, hedging against risk, locking in specific prices, and diversifying your portfolio.
That said, derivatives also come with a risk of default (in OTC trades), unlimited downside due to leveraging your positions, and a lack of liquidity in some markets. And because derivatives lack intrinsic value, they’re sensitive to fluctuations in supply and demand, interest rates, and holding costs.
What are the different types of financial derivatives?
Derivatives come in many types, including futures, forwards, options, swaps, warrants, and credits.
Why do we use derivatives in finance?
The original derivatives provided a way for farmers, ranchers, and other essential product providers to lock in prices and guarantee a market for their goods. Now, investors use derivatives to speculate, hedge against risk, lock in prices, and diversify their portfolios.
Bottom Line: What Is a Derivative?
Derivatives provide plenty of benefits – for those who make the right call. But there’s no way to avoid the unlimited downside risk if you’re wrong, and many derivatives trade in unregulated markets. As such, many investors prefer to leave these profitable-yet-risky investment tools to the experts.