If you are active in the investing world, you’ve most likely heard something about dealing in derivatives. While this kind of investing may be too risky for those new to the game, it can be a great option for more experienced investors.
So, how does it work?
Read on for a breakdown of the practice, advantages, and pitfalls of derivative investing.
What Is a Financial Derivative?
Derivatives are securities which are linked to other securities, such as stocks or bonds. Their value is based off of the primary security they are linked to, and they are therefore not worth anything in and of themselves.
There are literally thousands of different types of financial derivatives. However, most investment and financial engineering strategies revolve around the following three:
Options are contracts between two parties to buy or sell a security at a given price. They are most often used to trade stock options, but may be used for other investments as well. If an investor purchases the right to buy an asset at a particular price within a given time frame, he has purchased a call option. Conversely, if he purchases the right to sell an asset at a given price, he has purchased a put option.
Futures work on the same premise as options, although the underlying security is different. Futures were traditionally used for purchasing the rights to buy or sell a commodity, but they are also used to purchase financial securities as well. It is possible to purchase an S&P 500 index future, or a future associated with a particular interest rate.
Swaps give investors the opportunity to exchange the benefits of their securities with each other. For example, one party may have a bond with a fixed interest rate, but is in a line of business where they have reason to prefer a varying interest rate. They may enter into a swap contract with another party in order to exchange interest rates.
Advantages of Derivatives
Derivatives are sound investment vehicles that make investing and business practices more efficient and reliable.
Here are a few reasons why investing in derivatives is advantageous:
- Non-Binding Contracts
When investors purchase a derivative on the open market, they are purchasing the right to exercise it. However, they have no obligation to actually exercise their option. As a result, this gives them a lot of flexibility in executing their investment strategy. That being said, some derivative classes (such as certain types of swap agreements) are actually legally binding to investors, so it’s very important to know what you’re getting into.
- Leverage Returns
Derivatives give investors the ability to make extreme returns that may not be possible with primary investment vehicles such as stocks and bonds. When you invest in stock, it could take seven years to double your money. With derivatives, it is possible to double your money in a week.
- Advanced Investment Strategies
Financial engineering is an entire field based off of derivatives. They make it possible to create complex investment strategies that investors can use to their advantage.
The concept of derivatives is a good one. However, irresponsible use by those in the financial industry can put investors in danger. Famed investor Warren Buffet actually referred to them as “instruments of mass destruction” (although he also feels many securities are mislabeled as derivatives).
Investors considering derivatives should be wary of the following:
- Volatile Investments
Most derivatives are traded on the open market. This is problematic for investors, because the security fluctuates in value. It is constantly changing hands and the party who created the derivative has no control over who owns it. In a private contract, each party can negotiate the terms depending on the other party’s position. When a derivative is sold on the open market, large positions may be purchased by investors who have a high likelihood to default on their investment. The other party can’t change the terms to respond to the additional risk, because they are transferred to the owner of the new derivative. Due to this volatility, it is possible for them to lose their entire value overnight.
- Overpriced Options
Derivatives are also very difficult to value because they are based off other securities. Since it’s already difficult to price the value of a share of stock, it becomes that much more difficult to accurately price a derivative based on that stock. Moreover, because the derivatives market is not as liquid as the stock market, and there aren’t as many “players” in the market to close them, there are much larger bid-ask spreads.
- Time Restrictions
Possibly the biggest reason derivatives are risky for investors is that they have a specified contract life. After they expire, they become worthless. If your investment bet doesn’t work out within the specified time frame, you will be faced with a 100% loss.
- Potential for Scams
Many people have a hard time understanding derivatives. Scam artists often use derivatives to build complex schemes to take advantage of both amateur and professional investors. The Bernie Madoff ponzi scheme is a good example of this.
Who Should Invest in Derivatives?
For the reasons listed above, this is a very tough market for novice investors. Therefore, it is made up primarily of professional money managers, financial engineers, and highly-experienced investors.
While any investor can no doubt dabble in derivatives to test things out, beginners should not take high risks in this market given the potential dangers. As you become more savvy and familiar with the various types of derivatives and strategies that suit your investment style, you can start to incorporate them further into your personal investment portfolio.
With that said, it is important to note that regardless of your experience and knowledge, derivatives should only make up a portion of your investment portfolio. Because they can be so volatile, relying heavily on them could put you at serious financial risk.
Derivatives are complicated financial instruments. They can be great tools for leveraging your portfolio, and you have a lot of flexibility when deciding whether or not to exercise them. However, they are also risky investments. If you plan on purchasing a derivative, make sure that you are mindful of the specified time frame and are prepared to deal with the fact that they are volatile investment tools. In the right hands, and with the right strategy, derivatives can be a valuable part of an investment portfolio.
Do you have experience investing in financial derivatives? Please pass along any words of advice in the comments below.