What are Financial Derivatives – Common Derivatives Trading Examples

financial derivatives market manIf 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:

  1. Options
    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.
  2. Futures
    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.
  3. Swaps
    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:

  1. 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.
  2. 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.
  3. 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.

Potential Pitfalls

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Final Word

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.

  • kurtis hemmerling

    Thanks for the informative article outlining some of the risks of options. I do trade them and you are correct that they can be complex and fast money losers if you are not aware of the ins and outs such as Greeks, strike prices, likelihood of being in the money, and the list goes on.

    One interesting thing that you can do with options though to look for an abnormal amount of calls or puts being traded. One research paper in the Journal of Finance a couple decades ago brought out that there is a link between informed investors and the options market. Its a nice way of saying that those with quasi-insider knowledge buy on the options market in great quantities since options do not affect share price (although you can drive option prices up through a boost in implied volatility). Something to think about anyway.

    I’ve ranted too long already, thanks for the good piece and I look forward to more.

    • Butch Buckley

      Implied volatility? So, through insider trading and esoteric knowledge a stock can be manipulated, with enough purchasing clout, to be a cash cow. Exactly why ALL these motherfuckers need to go to jail. Meanwhile I get audited for claiming a haircut I claimed due to a presentation. Go fuck yourselves.

      • Alexander Smith

        Your an absolute moron or gringo if you tried to deduct a haircut on your tax return, maybe you should go back to Latin America where things work the way you want them to work!

  • Kalen Smith

    Thanks for the feedback Kurtis. Are you a professional trader if you don’t mind me asking? You sound very savvy as an investor.

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    A peace memorial tower on every state in the U.S and other developed countries can generate over
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  • rose chic

    I am teaching finance to undergraduates. This is a great stand alone piece. Thanks.

  • PP

    This is not an expert in derivative I can just see about your definition of Derivative same words missing.

  • MS


    Derivatives are not always worth nothing in and of themselves.
    If I have an option to buy the APPL stock at $100 expiring in Jan 2015, it is most certainly worth something. If you don’t agree, then give me some (for free since they are ‘not worth anything’) and we will see who laughs on his way to the bank. Spoiler alert: It would be me laughing.
    It says above that derivatives are priced based of the “primary security they are linked to.” This is also incorrect since derivatives can be linked to any number of securities (and are not limited to one).

    I didn’t bother reading more but I would guess that there are errors throughout – If the author can’t get the definition right then I would caution anyone from taking the advice that follows.

  • Ken Kossoudji

    Some counter points:

    Volatile prices – go ask anyone short GOOGL or NFLX how volatile those stock prices are today in contrast to the options? 18% up move today on top of an 8% move this week in a $600ish stock. – nuff said. Options and stock volatility are similar in that you can see what it is at any time and trade knowing that. Volatility is what creates the value.

    Overpriced? Really? Stocks and options have market determined prices and are priced accurately – neither over or under priced. The market determines price and stock prices have a 50/50 chance or rise/fall at any given moment. Unlike Schroedinger’s cat they cannot exist in both states at once.

    Time Value: A wise investor uses time decay to earn money. A stock can pay dividend or appreciate. An option can pay you for time decay or charge you for owning.

    Options are no more risky than stocks or bonds. In fact, when you trade options properly you can improve your odds of success at trade entry unlike a stock. A stock has a 50/50 potential and something like SPY has a 53% upward trends over time. However, I can put on an option trade with 10, 20, 50, 70, 90%, etc probability of winning. So technically, a 50/50 chance of success is a greater risk than a properly placed option trade with an entry probability of success at say 70%. So…which is more risky 70% or 50%…..lots to learn about derivatives…