What are derivatives?
Derivatives are not to be taken lightly. Often left to experienced investors, the world of derivatives has become fairly complex. So if you’re interested in exploring derivatives trading, it’s worth learning the fundamentals before deciding whether it’s for you.
Seen as a way to offset risk, professional traders are more likely to be trading in derivatives than part-time investors are. Therefore, knowing how they work and the various types available to investors is necessary if you want to start trading.
What are derivatives?
A derivative is a financial contract based on the value of an underlying asset, group of assets, or benchmark. Types of derivatives include options, futures, forward contracts, and warrants.
These contracts are set between two or more parties that can trade on an exchange or over the counter (i.e., via a broker-dealer network). Exchange-traded derivatives are regulated, but over-the-counter derivatives are not.
The type of asset involved in a derivative can vary and can include stocks and bonds, currencies, interest rates, commodities, market indexes, and, more recently, cryptocurrencies.
At their core, derivatives are a way to make money from risk without owning these assets. Instead, they are considered a form of advanced investing based on a contract for an asset that will see fluctuations in its value.
How do derivatives work?
The fluctuations in the underlying asset determine the value of a derivative. In some shape or form, they have been around for centuries; farmers and tradespeople would hedge their produce against future price fluctuations, agreeing on a contract before any goods were exchanged. The contract itself is the derivative rather than the asset.
Derivatives operate on the principle of risk transfer. When entering into a derivative contract, investors are doing so with clearly defined terms for how all parties involved will respond to future changes in the underlying asset's value.
These types of contracts can be used for businesses and investors to lock in prices or hedge against unfavorable rate movements. They can also be used to mitigate risk. However, since derivatives are based on the price of another asset, they are difficult to value – making them vulnerable to market risk.
What are the different types of derivatives?
In modern trading, derivatives can involve all manner of contracts and transactions. Different types can be used for different purposes, from risk management to speculation. As the market for derivatives continues to grow, more and more products are available to meet needs across the risk tolerance spectrum.
The most common derivative types are futures, forwards, swaps, and options. Every day investors tend to only deal with futures and options, but below we’ll examine the definitions of all four.
This is the oldest type of derivative contract. In fact, the first of its kind is often thought to have involved the Greek philosopher Thales, who – according to Aristotle – engaged in a contract on the price of olives before the following year’s harvest began.
At its core, a futures contract is an agreement between two parties to buy and deliver an asset at a price agreed for a future date. Futures contracts are often utilized by traders, who hedge their risk or speculate on the price of an underlying asset. For example:
Jan 5, 2023: Company A needs oil in February and is worried about the price rising before it needs to buy.
Company A buys a futures contract for oil at $70 a barrel, and this contract expires on Feb 15, 2023.
The oil company is now obligated to deliver oil to Company A for $70 per barrel once the contract is expired.
Feb 15, 2023: Prices have risen to $80 per barrel. Company A can now either accept the delivery of the oil from the seller of the futures contract.
Alternatively, if Company A no longer needed the oil, it could have sold the contract itself before the expiration date and kept the profit.
Similar to futures, forwards contracts will see buyer and seller customize the terms and settlement process between them over-the-counter exclusively since they don’t trade on an exchange.
Since over-the-counter contracts are unregulated, forwards derivatives carry more risk. For example, if one of the parties involved becomes insolvent, the other party may lose the value of its position with no recourse.
A swap derivative is often used to exchange cash flows or liabilities to increase profits or reduce costs. Swaps usually occur with interest rates, commodities, currencies, or credit defaults.
One example of a swap derivative is if Company X enters into a contract to exchange a variable-rate loan for a fixed-rate loan with Company Y. In doing so, Company X will aim to protect itself from a future rise in rates. Meanwhile, Company Y is betting on its fixed rate, earning a profit that can cover rate increases incurred from the variable rate loan.
This type of derivative generally isn’t available to individual investors.
An options derivative is a non-binding version of a future or forwards contract. An agreement is drawn up to exchange an asset at a certain price and at a certain time, but the buyer in the contract is under no obligation to use it. As such, this type of derivative requires buyers to pay a premium representing the agreement’s value.
How do I invest in derivatives?
Before you make moves in the world of derivatives, it’s important to ensure your finances are secure. Do you have an emergency fund, retirement contributions, and a balanced portfolio? Even if this is the case, investing significant portions of your wealth in derivatives is not advisable.
However, suppose you are confident in your approach to derivatives. In that case, investing is fairly straightforward: purchasing fund-based derivative products through a typical investment account, such as a leveraged mutual fund or an exchange-traded fund (ETF). Or, if you’re looking to invest in derivatives directly, some brokerages (but not all) will allow you to place options and futures trades as an individual investor.
Derivatives can be extremely complex and are rarely recommended for everyday investors with little knowledge of the subject.
However, if you are interested in investing in derivatives, it’s highly recommended that you first speak with an expert financial advisor. Their broad knowledge can offer crucial insight into how you might invest in derivatives and will ensure you have a more comprehensive picture of whether or not it’s the right route. Find a financial advisor for managing your finances with Unbiased today.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.