A derivative is a financial instrument that derives its value from something else. Because the value of derivatives comes from other assets, professional traders tend to buy and sell them to offset risk. For less experienced investors, however, derivatives can have the opposite effect, making their investment portfolios much riskier.
What Are Derivatives?
Derivatives are complex financial contracts based on the value of an underlying asset, group of assets or benchmark. These underlying assets can include stocks, bonds, commodities, currencies, interest rates, market indexes or even cryptocurrencies.
Investors enter into derivative contracts that clearly state terms for how they and another party will respond to future changes in value of the underlying asset.
Derivatives may be traded over-the-counter (OTC), meaning an investor purchases them through a brokerage-dealer network, or on exchanges like the National Stock Exchange in India.
While exchange-traded derivatives are regulated and standardized, OTC derivatives are not. This means that you may be able to profit more from an OTC derivative, but you’ll also face more danger from counterparty risk, the chance that one party will default on the derivative contract.
Types of Derivatives
You’re most likely to encounter four main types of derivatives: futures, forwards, options and swaps. As an everyday investor, you’ll probably only ever deal directly with futures and options, though.
With a futures contract, two parties agree to buy and sell an asset at a set price on a future date.
Because futures contracts bind parties to a particular price, they can be used to offset the risk that an asset’s price rises or falls, leaving someone to sell goods at a massive loss or to buy them at a large markup. Instead, futures lock in an acceptable rate for both parties based on the information they currently have.
Notably, futures are standardized, exchange-traded investments, meaning everyday investors can buy them about as easily as they can stocks, even if you personally don’t need a particular good or service at a particular price. Gains and losses are settled daily, meaning you can easily speculate on short-term price movements and aren’t tied to seeing out the full length of a futures contract.
Because futures are bought and sold on an exchange, there’s much less risk one of the parties will default on the contract.
Forward contracts are very similar to futures contracts, except they are set up OTC, meaning they’re generally private contracts between two parties. This means they’re unregulated, much more at risk for default and something average investors won’t put their money into.
While they introduce more risk into the equation, forwards do allow for much more customization of terms, prices and settlement options, which could potentially increase profits.
Options function as non-binding versions of futures and forwards: They create an agreement to buy and sell something at a certain price at a certain time, though the party buying the contract is under no obligation to use it. Because of this, options typically require you to pay a premium representing a fraction of the agreement’s value.
In the future if your expected price falls below the spot price, you still have an option to purchase, “put options”. It means, you will be provided with the benefit to sell at the strike price on the expiration date. You have no obligation to implement your rights here. On the other hand, the seller has all the rights to buy the gold at the strike price on the expiration date with no obligation in the “call option” category. It completely depends on the seller whether he implements his rights on the expiration date.
Options can trade on exchanges or OTC. In India, options can be traded on indices and on single stocks via NSE. When they are traded on an exchange, options are guaranteed by clearinghouses and are regulated by the the Securities and Exchange Board of India, which decreases counterparty risk. Like forwards, OTC options are private transactions that allow for more customization and risk.
Swaps allow two parties to enter into a contract to exchange cash flows or liabilities in an attempt to either reduce their costs or generate profits. This commonly occurs with interest rates, currencies, commodities and credit defaults, the last of which gained notoriety during the 2007-2008 housing market collapse, when they were overleveraged and caused a major chain reaction of default.
The exact way swaps play out depends on the financial asset being exchanged. For the sake of simplicity, let’s say a company enters into a contract to exchange a variable rate loan for a fixed-rate loan with another company. The company getting rid of its variable rate loan is hoping to protect itself from the risk that rates rise exponentially.
The company offering the fixed rate loan, meanwhile, is making a bet that its fixed rate will earn it a profit and cover any rate increases that come from the variable rate loan. If rates go down from where they currently are, all the better.
Swaps carry a high counterparty risk and are generally only available OTC to financial institutions and companies, rather than individual investors.
How Are Derivatives Used?
Because they involve significant complexity, derivatives aren’t generally used as simple buy-low-sell-high or buy-and-hold investments. The parties involved in a derivative transaction may instead be using the derivative to:
- Hedge a financial position. If an investor is concerned about where the value of a particular asset will go, they can use a derivative to protect themselves from potential losses.
- Speculate on an asset’s price. If an investor believes an asset’s value will change substantially, they can use a derivative to make bets on its potential gains or losses.
- Use funds more effectively. Most derivatives are margin-powered, meaning you may be able to enter into them putting up relatively little of your own money. This is helpful when you’re trying to spread money out across many investments to optimize returns without tying a lot up in any one place, and it can also lead to much greater returns than you could get with your cash alone. But it also means that you may be open to immense losses if you make the wrong bet with a derivatives contract.
Risk of Derivatives
Derivatives can be incredibly risky for investors. Potential risks include:
- Counterparty risk. The chance that the other party in an agreement will default can run high with derivatives, particularly when they’re traded over-the-counter. Because derivatives have no value in and of themselves, they’re ultimately only worth the trustworthiness of the people or companies who agree to them.
- Changing conditions. Derivatives that contractually obligate you to certain prices can lead to riches—or ruin. If you agree to futures, forwards or swaps, you could be forced to honor significant losses, losses that may be magnified by margin you took on. Even non-obligatory options aren’t without risk, though, as you must put forth some money to enter into contracts you might not choose to execute.
- Complexity. For most investors derivatives, particularly those based on investment types they’re unfamiliar with, can get complicated fast. They also require a level of industry knowledge and active management that may not appeal to investors used to traditional hands-off, buy-and-hold strategies.
How to Invest In Derivatives
Derivative investing is incredibly risky and not a good choice for beginner or even intermediate investors. Make sure you’ve got your financial basics, like an emergency fund and retirement contributions, squared away before you delve into more speculative investments, like derivatives. And even then, you won’t want to allocate substantial portions of your savings to derivatives.
That said, if you’d like to get started with derivatives, you can easily do so by purchasing fund-based derivative products using a typical investment account.
You might consider, for instance, a leveraged mutual fund or an exchange-traded fund (ETF), which can use options or futures contracts to increase returns, or an inverse fund, which uses derivatives to make investors money when the underlying market or index declines.
Fund-based derivative products like these help decrease some of the risks of derivatives, like counterparty risk. But they also aren’t generally meant for long-term, buy-and-hold investing and can still amplify losses.
If you want more direct exposure to derivatives, you may be able to place options and futures trades as an individual investor. Not all brokerages allow for this, though, so make sure your platform of choice is equipped for derivatives trading.