- Derivatives are contracts that derive their price from an underlying asset, index, or security.
- There are two types of derivatives: over-the-counter derivatives and standardized derivatives.
- Derivatives are used to hedge against risk and can be used to speculate.
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When you think of investing, you may be more familiar with stocks and bonds. Another type of investment vehicle that you may not be as familiar with is derivatives. While all investing in the stock market comes with inherent risk, some types of investments tend to be riskier than others. Derivatives fall into that camp.
What is a derivative?
Derivatives are a contract that has a value that’s derived from an underlying asset or index — hence the name “derivative.” One example of a type of derivative are options because its value changes in relation to the price movement of the underlying stock.
There are two types of derivatives: over-the-counter derivatives, which are negotiated privately, as well as standardized derivatives that can be traded on a standardized exchange. Over-the-counter derivatives, also known as OTC derivatives, are well-known to have caused the Great Recession by creating heightened demand for underlying assets like mortgages.
The start of the derivatives market began in 1865 when farmers and grain sellers came together to hedge risk against the corn market. These derivatives were used as part of hedging and speculating to lower risk, which can cause inflated prices that are subject to manipulation and fraud. These types of derivatives have been referred to as futures contracts, which we’ll cover later.
“Derivatives are unlike securities in that they are more of a bet than an investment. Most common derivative contracts have an expiration date, which means a limited time for them to achieve a profit,” explains Asher Rogovy, an SEC registered investment advisor and chief investment officer at Magnifina.
“Securities, on the other hand, are either perpetual or repayable, so investors can simply hold them for the long-term. The key benefit of derivatives over securities is leverage. If a trader has conviction about a price move within a certain time frame, they can gain a much higher profit by trading derivatives instead of the underlying security. Of course, with this higher profit potential, comes higher risk.”
Types of derivative contracts
Derivatives can be complicated as there are various different types of derivative contracts. Some common types of derivatives include:
- Options — this type of derivative allows the investor the option to buy or sell a security at a set price with a specific timeframe. If you purchase a “call option” you get the right to purchase shares at a later date. A “put option” offers you the ability to sell shares at a later date.
- Swaps — The United States Security Exchange Commission (SEC) states that “Swaps are financial contracts in which two counterparties agree to exchange or “swap” payments with each other as a result of such things as changes in a stock price, interest rate, or commodity price.”
- Futures — this is an arrangement where an investor can purchase or sell a set amount of a specific commodity at a set price at a future date. Future contracts are available to trade on an standardized exchange and are settled each day and can be purchased or sold off at any time.
- Forwards — forward contracts are very similar to futures contracts in that it is an arrangement to buy or sell a commodity at a set price, at a set time in the future. But it’s important to note that forward contracts are not traded on an exchange.
Derivative contracts can be traded either over-the-counter (OTC) or on exchanges such as the Chicago Mercantile Exchange Group (CME Group) or the Korea Exchange.
How do derivatives work?
Derivatives can be used in a variety of ways to hedge against risk or used as speculative tools. As a financial instrument, the value of derivative transactions are at the mercy of market conditions such as credit, equity, and interest rates.
According to the San José State University Department of Economics, derivatives and swaps play an important role in the economy by transferring risk. The risk is transferred to other parties who are willing to take it on for a fee. In this way, derivatives are similar to the insurance industry where you hedge against risks such as the price of a stock dropping. But instead of it being called “insuring” it’s known as hedging.
You can hedge against risk with derivative contracts by purchasing a contract that has a value that will help offset any other losses you may have in other positions. Through hedging, investors strive to lower their risk of loss by having positions in the market that are opposite in order to minimize risk. Derivative contracts are arrangements between two entities — often referred to as a “counterparty” — that work together to reduce risk on their overall investment and the underlying asset.
Derivatives can also be used as a leveraging tool. In investing, leverage is when an investor maximizes the use of money that is borrowed to try and maximize profit. While this strategy can boost profits, it can also increase risk as well.
Speculation is a strategy where investors buy a type of asset like derivatives and speculate that the price will shift in the future. Given its name, this is more speculation than hard data. The investor using this strategy hopes to maximize profits but like the term suggests, it’s all speculative and can be very risky.
Pros and cons of derivatives
If you’re thinking of investing in derivatives, review the pros and cons first before getting started. This type of investment can have more moving parts and considerations as there is a counterparty and is based on underlying assets.
The financial takeaway
Derivatives are another investment tool that’s used to minimize risk while maximizing profits. It’s a complex financial vehicle that deals with assets that can shift in value but also provide opportunities to hedge against risk and use leverage to gain profits. It’s important to note that derivatives can be fraught with risk and the potential for fraud.
“Derivatives aren’t for beginner or casual investors. Because they are essentially bets, Wall Street does a very good job of making sure they are accurately priced,” notes Rogovy. “Because derivatives tend to expire, there’s less margin for error. With securities, some bad trades may be salvaged by holding for the long-term. Inexperienced traders are notorious for losing significant amounts of capital on risky stock option bets.”