Derivatives are financial instruments that derive their value from the value of an underlying asset. They're contracts to buy or sell shares of underlying stock, commodities (like gold or corn), currency, or other assets at a specified price on a specified date.
Investors often use derivatives to hedge their risks, maximize their returns, or limit losses. While available directly in the form of options or futures, the average investor can also access derivatives through funds that invest in them. However, they can be risky investments and are not appropriate for everyone. Take the time to understand what they are, how to use them, and the risks involved before trading derivatives.
What Is the Derivatives Market?
The derivatives market is one part of the financial market, which also includes the stock market, bond market, and commodities market. The derivatives market is where traders buy and sell different types of derivatives, such as options, futures, forwards, and swaps.
Options and futures are traded on regulated exchanges including the CME Group, New York Stock Exchange (NYSE), and Nasdaq. Forwards and swaps are privately negotiated, do not trade on an exchange, and are not available to the average investor. Forward contracts are also not regulated like options, futures, and swaps.
Options, futures, and swaps are regulated by the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).
Types of Derivatives
There are two basic types of derivatives:
- Contracts with an obligation to buy or sell an asset at a specified time and price
- Contracts with the right to buy or sell, but not the obligation
Futures and swaps are obligation contracts. Options are rights contracts, and can have stocks, bonds, and futures contracts as the underlying asset.
Option contracts give you the right to buy or sell the underlying securities—stocks, bonds, commodities, or even futures contracts.
Options are quoted with a price for the contract (premium), an expiration date, and a price for the asset (strike price). Options contracts are primarily of two types, calls or puts, and investors can use different options strategies to make successful trades.
Investors profit from calls when the price of the underlying stock or future rises above the strike price plus the premium for the contract. Investors profit from puts when the price of the underlying asset falls below the strike price plus the premium.
Futures contracts have standard provisions. They specify the product, quantity, quality, price, location, and date of delivery. The product can be physical, like corn, or financial, like dollars or bonds. Contract prices are quoted on each exchange and are continuously updated.
Futures can also be used to buy and sell the price of a financial index, like the S&P 500. Index futures contracts specify the index used, the quantity, the price, and the date of settlement. Since index prices are not a physical asset, there is only a cash transaction at settlement—there’s no delivery of product. If the price of the index is higher than the contract price at settlement, the buyer makes a profit. If the index is lower than the contract price, the seller makes a profit.
Futures contracts have a value, and options are traded for the right to buy or sell them.
Some businesses and traders may have a specific need to protect a price that is not available in a standard futures contract. Forwards are customized futures contracts that are negotiated between a buyer and a seller. They don't trade on an exchange and aren't regulated. Because of these reasons, they carry a higher risk of default, making them unsuitable for the average investor.
Swaps facilitate an exchange of securities, either with different maturities or with different cash flows. The common types of swaps include commodity swaps, currency swaps, credit default swaps, and interest rate swaps.
An example of a swap would be one U.S. company that borrows money and pays interest on that money in dollars, but sells its products in France and gets paid in Euros. If the Euro decreases in dollar value, the company loses money. The U.S. company might look for a French company that borrows in Euros and gets paid in dollars. They could agree to swap a set amount of dollars and Euros at an agreed rate of exchange for a set period of time.
How Does Trading Derivatives Work?
There is always a buyer and a seller in any derivatives transaction. A derivative contract buyer holds a long position while a derivative contract seller holds a short position.
Investors generally use the derivatives market for two purposes: hedging and speculation
Hedging is a risk management strategy to offset short-term price fluctuations or volatility. Portfolio managers and traders may purchase call options to protect their shorted stocks against a rise in prices. Hedge fund managers often make extensive use of derivatives to enhance returns and manage risk. Manufacturers may purchase futures to manage fluctuations in the price of materials or currencies they need to use to make purchases in foreign markets. Farmers may use futures to guarantee a sale price for their crops.
Speculators, like day traders, trading firms, and arbitrageurs, look to profit from short-term changes in price, up or down. Speculators use the derivatives market because it’s a source of leverage using margins.
Options and futures contracts enhance returns because they give investors control of large amounts of stocks or commodities without having to buy or sell them until a later date.
What Do Derivatives Mean to the Average Investor?
Derivatives are complex and risky investments that may not be suitable for all investors.
Leveraged exchange-traded funds (ETFs), inverse ETFs, and managed futures are a way for the average investor to capitalize on a professionally managed broad portfolio of derivatives using small amounts of money.
Leveraged and inverse ETFs are available to track a wide variety of financial and commodities indexes. Leveraged ETFs use derivatives to enhance the positive returns of an index. A 2x leveraged ETF is constructed to produce twice the returns of an index, positive and negative. Inverse ETFs profit when the price of an index falls.
Managed futures are a portfolio of futures contracts across a broad spectrum of commodities, currencies, and financial indexes. The average investor can use a managed futures mutual fund or ETF to diversify their portfolio and manage risk.
Pros and Cons of Trading Derivatives
- Manage risk
- Allows for speculation
- Very risky
- Complex and not always transparent
For the average investor, derivatives offer a way to diversify their portfolio and manage risk. Managed futures are a way to invest in assets that don’t correlate, or rise and fall, with the stock and bond markets. Inverse ETFs can protect against market declines and leveraged ETFs are a way to speculate on market price directions. Then there are options, which offer a way to speculate on individual stocks using relatively small amounts of money.
It’s important to always remember that derivatives are volatile, with a greater risk of loss—in some cases, an unlimited potential loss. They are complex and not always transparent investments. You should be familiar with the strategies and risks before you invest.
The Bottom Line
Derivatives are a way to enhance the returns of your portfolio, protect yourself from falling prices, and diversify with assets like commodities. There are many ways to invest in derivatives, including through ETFs and mutual funds. Derivatives are a widely used tool in active, or day trading, too. Be sure you understand the strategies and risks before investing in or trading derivatives.