What Are Derivatives in Finance?

When most people think about investing, stocks and bonds often come to mind. After all, these assets are fairly easy to understand and form the bedrock of most portfolio strategies. Stocks represent partial ownership of a company, while bonds represent ownership of debt.

But there’s more to investing than stocks and bonds. Investors seeking a higher level of diversification or who are willing to take on increased risk in exchange for greater growth potential will sometimes allocate a portion of their portfolios to other types of investments—like derivatives.

Not sure what derivatives are? Below, we’ll answer common questions to give you a better sense of the role that derivatives might play in a portfolio .

What are derivatives, and how do they work?

At its heart, a derivative is a financial contract that outlines the terms of a transaction that may take place on some future date. Usually, it gives the contract holder either the right or the obligation to buy or sell an asset at a given price.

The term “derivative” comes from the fact that the value of the contract is “derived” from an underlying asset, like a stock, bond, commodity, etc. Whether or not an investor makes money from a derivative will depend on the price action of the underlying asset—i.e., whether it goes up or down—relative to the agreed-upon terms. If an investor correctly anticipates how the underlying asset’s value will move, they will profit from the derivative.

Options and futures are the most common types of derivatives that the average investor might encounter. Other types of derivatives include swaps, forward contracts and collateralized debt obligations.

Because derivatives are not themselves assets, they fall into the category of secondary securities.

Why do investors use derivatives?

Investors will typically use derivatives for one of three main reasons: to speculate on an asset’s price action, to increase their leverage or to hedge a position.

Increasing leverage

Derivative contracts can allow you to speculate on the price movements of an asset without actually buying the asset. With this in mind, by using derivatives, an investor has the ability to reap larger benefits than if they’d purchased an asset outright. But the opposite can also be true.

Hedging a position

Hedging allows investors to limit risk by locking in a price for a good or asset at a future date. For instance, farmers might use this tool to guarantee a price paid for their crops before they even plant them.

Speculating on price movement

Because derivatives are relatively inexpensive, they can also be a cost-effective means for betting that the future price of an asset will increase or decrease.



It should also be noted that derivatives themselves also have value, based on the likelihood that they will generate value for the contract holder. With this in mind, they can be traded on the derivatives market, just like stocks and bonds are traded on the stock market and bond market.

What are the basic types of derivatives?

The word “derivatives” is actually an umbrella term used to refer to multiple different types of financial contracts. Each of these types of derivatives works differently, so it’s important to understand their differences.

Options

An option is a derivative contract that gives an investor the ability to either purchase (call option) or sell (put option) an asset at an agreed-upon price for a certain period of time. It can be used to purchase many different types of assets, including stocks, bonds, commodities, indexes and even foreign currencies.

While there are many options strategies that investors can use, the general idea is that they allow an investor to lock the price of an asset, with the hopes that that price will be better than the price available directly from the market on the date that the option is executed.

If an investor believes that the price of an asset will go up in the future, for example, they might purchase a call option that entitles them to purchase the asset at a cheaper price. Then, if the asset appreciates in value, the investor can exercise the option to get the asset at the lower, agreed-upon price. The investor can then either hold onto the asset or immediately sell it for a profit.

It should be noted that the options discussed above are very different from employee stock options. With employee stock options, your employer allows you to purchase shares of the company at a set price, which is typically lower than what is available to the general public.

Futures

Futures are very similar to options, but with one key difference. While options give an investor the option to either buy or sell an asset at an agreed-upon price on a future date, a future requires the investor to buy or sell the asset. It is an obligation—rather than simply a right—to complete the agreed-upon transaction.

Investors use futures in the same way and for the same reason they use options: to give themselves a price advantage over the market. While futures are riskier than options, some investors prefer them to options because they can be easier to value, are more liquid and can allow for greater margin use than options do.

Other derivatives

While futures and options are the two main types of derivatives available to retail investors, there are many other types as well. Most of these are highly complicated and not readily available to the average investor. They include:

• Swaps: These derivatives establish a contract to exchange cash flows or financial obligations—like interest rates, currencies, credit defaults and more—in the future.

• Collateralized debt obligation: These are complex financial products backed by assets or other loans, typically used by institutional investors to generate income.

• Forwards: Similar to futures, forwards are sold only “over the counter” instead of via an exchange, making them potentially less liquid and riskier than futures.

Pros and cons of trading derivatives

Like almost anything financial, there are pros and cons when it comes to derivatives.

Pros of derivatives trading

• Derivatives allow investors to hedge the risks associated with their investing positions.

• Derivatives make it possible to lock in prices that may be more favorable than what’s available on the market.

• Derivatives offer exposure to an asset without needing to actually purchase it.

• Derivatives allow investors to invest on margin, which can give them access to a larger amount of assets with less capital than by directly purchasing shares.

Cons of derivatives trading

• Derivatives can be incredibly complex and difficult to understand, raising the prospect of costly errors.

• Because derivatives allow investors to buy on margin, it’s possible to lose more than the initial investment.

• Derivatives can be illiquid and difficult to sell, depending on the type of derivative and the asset underlying it.

• Purchasing derivatives requires a fee, or premium, which can be higher than trading costs associated with other assets.

Who should trade derivatives?

Derivatives can be a powerful tool for the right investor, but they can also be very complicated and risky if you don’t know what you’re getting into. With this in mind, they’re typically not a good choice for average investors.

This article is for informational and educational purposes only and should not be interpreted as financial or investment advice. All investments carry some level of risk including the potential loss of all money invested.