A derivative is a financial instrument that derives its value from something else. Since the value of derivatives comes from other assets, professional traders tend to buy and sell them to offset the 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, stock indices, or even cryptocurrencies.
Investors enter into derivative contracts that clearly set out the terms of how they and another party will react to future changes in the value of the underlying asset.
Derivatives can be traded over-the-counter (OTC), which means an investor buys them through a network of brokers 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 get more out of an OTC derivative, but you will also face greater risk of counterparty risk, the possibility that one party will default on the derivative contract.
Types of derivatives
You are most likely to come across four main types of derivatives: futures, forwards, options, and swaps. As an ordinary investor, you will probably only ever deal directly in futures and options.
With a futures contract, two parties agree to buy and sell an asset at a set price on a future date.
Since futures contracts bind parties to a particular price, they can be used to offset the risk of an asset’s price going up or down, leaving someone to sell goods at a massive loss or buy them with a margin. important. Instead, futures contracts set a rate acceptable to both parties based on the information they currently have.
Notably, futures contracts are standardized, exchange-traded investments, meaning ordinary investors can buy them as easily as stocks, even if you personally don’t need a particular good or service. at a particular price. Gains and losses are settled daily, which means you can easily speculate on short-term price movements and don’t have to see the full length of a futures contract.
Since futures contracts are bought and sold on an exchange, there is much less risk that either party will honor the contract.
Futures contracts are very similar to forward contracts, except that they are established over-the-counter, which means that they are usually private contracts between two parties. That means they’re unregulated, much more at risk of default, and something average investors won’t invest their money in.
Although they introduce more risk into the equation, futures contracts allow for much greater customization of terms, prices, and settlement options, which could potentially increase profits.
Options work like non-binding versions of futures and futures contracts: they create an agreement to buy and sell something at a certain price at a certain time, although the party buying the contract is not obligated to do so. utilize. For this reason, options generally require you to pay a premium representing a fraction of the deal value.
In the future, if your predicted price falls below the spot price, you always have an option to buy, the “put options”. This means that you will have the advantage of selling at the strike price on the expiration date. You have no obligation to enforce 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 without obligation in the “call option” category. It is entirely up to the seller if he implements his rights on the expiration date.
Options can be exchange-traded or over-the-counter. In India, options can be traded on indices and individual stocks through NSE. When traded on an exchange, options are guaranteed by clearing houses and are regulated by the Securities and Exchange Board of India, which reduces counterparty risk. Like futures, 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 with the aim of reducing their costs or generating profits. This usually happens with interest rates, currencies, commodities and credit defaults, the last of which gained notoriety during the housing market crash of 2007-2008, when they were overleveraged and caused a major chain reaction of default.
Exactly how swaps work out depends on the financial asset being traded. For simplicity, suppose a company enters into a contract to swap a floating rate loan for a fixed rate loan with another company. The company that gets rid of its variable rate loan hopes to protect itself from the risk of an exponential rise in rates.
The company offering the fixed rate loan, on the other hand, is betting that their fixed rate will earn them a profit and cover any rate increases that arise from the variable rate loan. If rates fall from their current level, so much the better.
Swaps carry high counterparty risk and are generally only available over-the-counter to financial institutions and corporations, rather than to individual investors.
How are derivatives used?
Because they involve great complexity, derivatives are generally not used as simple buy-low-sell-high or buy-and-hold investments. Parties involved in a derivative transaction may instead use the derivative to:
- Cover a financial situation. If an investor is worried about the evolution of the value of a particular asset, he can use a derivative to protect himself against potential losses.
- Speculate on the price of an asset. If an investor thinks the value of an asset will change significantly, they can use a derivative to bet on its potential gains or losses.
- Use funds more efficiently. Most derivatives are margin-powered, which means you may be able to participate in them with relatively little of your own money. This is useful when trying to spread the money across many investments to maximize returns without tying up a lot of money in one place, and it can also lead to returns far greater than you could get with your money alone. But it also means that you can be exposed to huge losses if you make the wrong bet with a derivative contract.
Derivatives can be extremely risky for investors. Potential risks include:
- Counterparty risk. The likelihood of the other party to an agreement defaulting can be high with derivatives, especially when traded over-the-counter. Because derivatives have no value on their own, they are ultimately only worth the reliability of the people or companies who accept them.
- Changing conditions. Derivatives that contractually bind you to certain prices can lead to wealth or ruin. If you accept futures, forwards or swaps, you may be forced to sustain significant losses, losses which may be magnified by the margin you have taken. Even non-binding options are not without risk, as you have to invest money to enter into contracts that you may not choose to perform.
- Complexity. For most investors, derivatives, especially those based on investment types they are unfamiliar with, can get complicated quickly. They also require a level of industry knowledge and active management that may not appeal to investors accustomed to traditional 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 have your financial basics, like an emergency fund and retirement contributions, squared off before diving 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 want to get into derivatives, you can easily do so by buying fund-based derivatives using a typical investment account.
You might consider, for example, a leveraged mutual fund or exchange-traded fund (ETF), which can use options or futures to increase returns, or an inverse fund, which uses derivatives to make money for investors when the underlying market or index declines.
Fund-based derivatives like these help reduce some of the risks of derivatives, such as counterparty risk. But they are also generally not intended for long-term investment and can further magnify losses.
If you want more direct exposure to derivatives, you may be able to place options and futures as an individual investor. However, not all brokerages allow this, so make sure your platform of choice is equipped for derivatives trading.