What are financial derivatives?
If you follow investing news or talk to other investors, you’ve probably heard talk about derivatives like options or futures.
Derivatives can be powerful tools for advanced investors who want to hedge their investments or structure their portfolio to profit from specific changes in the market. For inexperienced investors, they can be incredibly confusing and risky, leading to significant losses.
What Is a Financial Derivative?
Derivatives are financial instruments that don’t represent a specific asset itself. Instead, its value is derived from an underlying asset — that is, it is a derivative of another security.
One of the most basic examples of derivative contracts is the option. Options give you the right to buy or sell a specific stock at a set price. The option derives its value from the value of its underlying stock.
Derivatives are a useful tool because they give people involved in financial markets ways to hedge against different risks. However, they can also be risky in themselves. Derivative instruments like interest rate swaps and other contracts traded by financial institutions contributed to the 2008 financial crisis.
Types of Financial Derivatives
There are hundreds of different types of financial derivatives out there. These three are the most common types of derivatives and most advanced investing strategies and complex derivatives involve them.
An option is a contract between two investors where they agree to a transaction involving a certain number of shares at a set price (called the strike price). One party writes (sells) the option while the other buys the option and holds it. The person who buys an option has to pay the person selling the option. The amount the buyer pays is called the option premium.
There are two main types of options: calls and puts.
A call option gives the holder the right to purchase the agreed-upon number of shares at a set price. For example, you might buy a call option that gives you the right to purchase 100 shares of company XYZ at $5 per share.
A call option is useful when an investor thinks a stock is going to increase in price. If company XYZ’s stock is trading at $6 on the open market, the option holder could exercise their option to purchase 100 shares for $500. If they immediately sell those shares on the open market, they’ll receive $600, profiting $100.
A put option is the opposite of a call option. It gives the holder the right to sell the agreed-upon number of shares at a set price. For example, you could buy a put option that lets you sell 100 shares of company ABC at $25 per share.
Put options are useful when an investor thinks a stock is about to drop in price. If ABC is trading on the open market at $20, the option holder could buy 100 shares for $2,000 and exercise the option to sell them for $2,500, profiting $500.
It’s important to note that the person who holds an option has the right, but not the obligation, to exercise it. In the above example, if XYZ is trading on the open market for $4, there’s no reason for the option holder to exercise the option to buy shares at $5.
Options contracts have an expiration date. If the holder doesn’t exercise the option before it expires, they lose the right to exercise it and the person who sold the option is no longer obligated to honor it. Typically, option holders will only exercise an option if it is profitable to do so.
People who sell options hope that the buyer will not exercise the option. If an option contract expires, no shares trade hands and the seller gets to keep the premium they received as payment as profit.
Options traders can choose to exercise these derivatives contracts or to sell them to other investors as their values change. The value of a contract will change based on the price movements of the underlying asset.
For example, call options contracts gain value as the price of the underlying asset increases.
Pro tip: If you’re thinking about trading options, make sure to check out our list of the best options trading platforms.
Futures are similar to options in that they are agreements between two investors to conduct a transaction at a set price by a certain future date. Typically, futures are more common in commodity trading.
For example, commodity futures let someone secure a price for goods like crude oil or corn. Futures can also be used to guarantee an exchange rate between currencies, which businesses can use to hedge against fluctuations in foreign currency values.
The primary difference between options and futures is that a futures contract includes an obligation to complete the transaction. Someone who holds an option can decide not to exercise it, allowing it to expire. Someone who owns a futures contract to purchase a quantity of a commodity at a set price must complete that purchase on the contract’s expiration date, regardless of the market price of that commodity.
In reality, most investors will sell their futures contracts or pay the seller of the contract to close the position before their expiration date to avoid the obligation to purchase and receive a delivery of a commodity, whether it be corn, oil, or cattle.
Futures can be a more complex derivatives market than options, so most everyday investors stick to options trading.
Swaps are relatively complex financial contracts which lets two parties exchange either the cash flows or the liabilities produced by financial assets.
For example, two people who hold different bonds may use a swap to continue holding the same bond, but to exchange the interest payments that they receive. This lets organizations trade based on the interest rate of different liabilities or securities. It also lets them exchange the credit risk for instruments like loans.
This could be useful if one party holds a bond that pays a variable rate of interest while another party holds a bond that pays a fixed rate. They can use a swap to exchange the interest payments from the bonds. Organizations sometimes use swaps as a hedging strategy, such as through credit default swaps.
Swaps are rarely used by everyday investors. They’re largely traded on over-the-counter (OTC) markets and are mostly used by institutions that want to hedge their risks.
Why Do Companies and Investors Use Derivatives?
Investors use derivatives for a number of reasons.
1. To Lock In Prices
One of the most common reasons to use a derivative is to guarantee a price for a commodity to reduce uncertainty.
Imagine a company that refines oil into gasoline. The price of a barrel of oil can be volatile. One day a barrel might cost $20 and the next it could cost $50. The gas producer needs to purchase oil on a regular basis to keep making gas, but because its price is volatile, it’s incredibly difficult for the company to predict its future costs.
The gas producer can use a futures contract to lock in a price for oil. This gives the gas producer a guarantee of how much it will pay for the oil it needs to keep running its business. That makes it easier for the company to budget and to know how much cash it needs to keep on hand.
2. To Hedge Against Risk
Derivatives are also useful for risk management in an investor’s portfolio. Someone who owns shares in a company might buy a put option to reduce their risk.
For example, if an investor holds 100 shares of company XYZ, which are currently worth $50 each, that investor could buy a put option with a strike price of $45. At any time before the contract expires, the investor could exercise that option and sell the shares for the specific price set in the option contract.
If the shares fall in price, the lowest price the investor will have to sell them for is $45, even if the shares are trading for less than that on the open market. This limits the investor’s loss to $5 per share, reducing their overall risk. Of course, if the shares rise in price, the investor will let the option expire and can keep the shares or sell them at their higher market price.
The investor does have to pay a premium to buy the option, but they may feel that the cost is worth the chance to limit their potential losses. Think of it like an insurance policy: you pay a premium upfront in order to limit your losses in case events don’t go your way.
3. For Leverage
Derivatives, especially options, are also commonly used as a form of leverage. One option contract typically includes 100 shares of the underlying security. If a company’s shares cost $300 each, an investor may be able to buy a call option that covers 100 shares for much less than that.
To use a real-world example, on September 3, 2020, SPY — an exchange-traded fund (ETF) that tracks the S&P 500 — traded at about $357 per share. That morning, you could buy a single call option covering 100 shares with a strike price of $375 and an expiration date of September 30, 2020, for $154.
For the price of roughly one share, an investor could gain control of 200 shares of SPY. A small increase in the ETF’s value will cause the value of the option to increase by a much larger amount because the option represents a greater number of shares.
Of course, the opposite is also true. If the ETF loses a small amount of value, the option will lose a large amount of value. This leverage is part of what makes derivatives so risky.
Advantages of Derivatives
There are many benefits of investing using derivatives.
1. Potential for More Complex Investing Strategies
Typically, when you buy an investment, you’re hoping it will increase in value or produce a cash flow. Without derivatives, there’s no way to profit from predicting a fall in an investment’s value. Derivatives provide a way to make money when you correctly predict that an asset will go down in price in the future. Derivatives also enable other complex strategies in which you can profit from volatility in an investment’s price or when the price remains steady.
2. Access to Otherwise Unavailable Markets
An everyday investor would have trouble investing directly in some commodities like oil or wheat. Few people have the proper space and equipment to store those commodities safely. Futures contracts can give investors a way to participate in those markets.
Derivatives let an investor control more shares in a company or an ETF with a smaller amount of capital, which increases their potential gains (and losses, of course).
Drawbacks of Derivatives
Derivatives aren’t the right investment for everyone, so it’s important to consider their drawbacks.
Derivatives are complicated and can be risky. The leverage that increases an investor’s gains also increases their potential losses. With certain derivatives, it’s possible to lose more money than you initially invested and in some cases the potential loss could be unlimited.
Again, the leverage involved with derivatives can make them highly volatile. Trading options is not a good choice for people who can’t handle huge swings in their portfolio’s value, as option prices can change by magnitudes more than the underlying stock’s price in a single day.
3. Expiration Dates
If you buy a stock or another asset, you can know with relative certainty that the asset will stick around for the long term. With the exception of a surprise bankruptcy, you wouldn’t expect a large business to close overnight. Derivatives like options have expiration dates, after which they become worthless. That makes it extremely important to monitor a portfolio of derivatives to make sure you don’t inadvertently let contracts expire.
Should You Use Financial Derivatives?
Derivatives aren’t a good choice for new investors or for people who want to maintain a simple, passive portfolio.
Instead, derivatives are for experienced, active investors who want to use them to try to profit from specific situations. For example, an investor who wants to hedge the risk of holding a volatile asset or an investor that wants to bet against a specific stock could benefit from using derivatives.
It’s important to emphasize that derivatives are highly volatile, risky investments. Some brokerage companies make it easy to trade options, but it is important to understand what you’re buying or selling when you do so. Depending on the derivatives you use, your potential loss could be higher than the amount of money you invest.
Derivatives are financial securities that derive their value from other securities. Investors can use them to hedge risk in their portfolio, for leverage, or to reduce the uncertainty created by volatility in commodity prices.
Derivatives can be highly volatile and risky, so most investors should probably stay away from them. If you don’t want to deal with complicated securities, consider investing in a passive portfolio, such as index funds or target-date funds, or working with a robo-advisor instead.
If you like the idea of managing your own portfolio and don’t mind the risks involved, you can consider trading derivatives. You can also try your hand at trading derivatives by using a trading simulator before investing with real money.