A derivative is a financial instrument whose value derives from an underlying asset such as a stock, a bond, interest rates, a commodity, an index, or even a basket of cryptocurrencies such as spot ether ETFs.
Derivatives can be complex financial instruments that subject novice users to increased risk. However, they are often used for three primary purposes: to hedge, speculate, or leverage a position.
There are manyderivative instruments, including options, swaps, futures and forward contracts, and collateralized debt obligations. Derivatives have numerous uses and various levels of risksbut are generally considered a soundway for an experienced trader to participate in the financial markets.
Key Takeaways
- A derivative is a security whose underlying asset dictates itspricing,risk, and basic term structure.
- Investors use derivatives to hedge a position, increase leverage, or speculate on an asset's movement.
- Derivatives can be bought or sold over the counter or on an exchange.
- There are many types of derivative contracts including options, swaps, and futures or forward contracts.
- Some risks associated with derivatives include market risk, liquidity risk, and leverage risk.
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A Quick Review of Terms
Derivatives can initially seem confusing, but familiarity with their lingo will help the new user begin to understand them. For instance, many instruments have counterpartieswho take the other side of the trade.
Each derivative has an underlying asset thatdictates itspricing, risk, and basic term structure. The underlying asset can be anything from stocks and bonds to commodities or economic indicators. The perceived risk of the underlying asset influences the perceived risk of the derivative.
The structure of the derivative may feature a strike price. This is the price at which it may be exercised. Fixed income derivatives may have a call price, which signifiesthe price at which an issuer can convert a security.
Manyderivativesforcethe investor to take a bullish stance with a long position, a bearish stance with a short position, or a neutral stance with a hedged position that can include long and short features.
How Derivatives Can Fit Into a Portfolio
Hedge to Protect Value
Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement. Hedging a position is usually done to protect or insure against the adverse price movement risk of an asset.
For example, the owner of a stock buys a put optionon that stock to protect their portfolio against a decline in the price of the stock. In other words, they take opposite positions on the same security.
The strategy is that if prices decline and they lose money on the stock, they will simultaneously make money on the put option (since the put should gain in value). This gain can offset the drop in the value of their stock.
On the other hand, if the stock price rises as hoped, theshareholder makes money on the appreciation in value of the stock in their portfolio. However, they also lose money on the premium paid for the put option.
A shareholder who hedges understands that they could make more money without paying for the insurance offered by a derivative if prices move favorably. However, if prices move against them, the hedge is in place to limit their loss.
The Power of Leverage
Derivatives can greatly increase leverage.For derivatives, leverage refers to the opportunity to control a sizable contract value with a relatively small amount of money. Leveraging through options works especially well in volatile markets. When the price of the underlying asset moves significantly andin a favorable direction, optionsmagnify this movement.
Many investors watch the CBOE Volatility Index (VIX) to measure potential leverage because italso predictsthe volatility of S&P 500 index options. High volatility can increasethe value and cost of both puts and calls.
Speculation
Investors also use derivatives to bet on the future price of the asset through speculation. Large speculative plays can be executed cheaplybecause options offer investors the ability to leverage their positions at a fraction of the cost of an equivalent amount of underlying asset.
Derivatives can greatly increase leverage. When the price of the underlying asset moves significantly andin a favorable direction, optionsmagnifythismovement.
Trading Derivatives
Derivatives can be bought or sold over-the-counter (OTC) oron an exchange. OTC derivatives are contracts that are made privately between parties, such as swap agreements, in an unregulated venue.
On the other hand, derivatives that trade on an exchange are standardized contracts. There is counter-party riskwhen trading over the counter because contracts areunregulated, while exchange derivatives are not subject to this risk due to clearing houses acting as intermediaries.
Risks of Derivatives
Risks associated with derivatives come in various forms. Market risk is one. Liquidity risk is another. So is the leverage risk of adverse market moves where large margin amounts may be demanded. There's the risk of trading on unregulated exchanges. For complex derivatives derived from more than one asset, there's also the risk that a proper value cannot be determined for the derivative.
Types of Derivatives
There are three basic types of contracts. These include options, swaps, and futures/forward contracts. All three have many variations. Options are contracts that give investors the right but not the obligation to buy or sell an asset. Investors typically use option contracts when they don't want to takea position in the underlying asset but still want exposure in case of large price movements.
There are dozens of options strategies, but the most common include:
- Long call: You believe a security'sprice will increase. You buy (go long) the right to own(call) the security. As the long call holder, the payoff is positive if the security'smarket price exceeds the exercise price by more than the premium paid for the call.
- Long put: You believe a security'sprice will decrease. Youbuy (go long) the right to sell (put) the security. As the long put holder, the payoff is positive if the security'smarket price is below the exercise price by more than the premium paid for the put.
- Short call: You believe a security'sprice will decrease. Yousell (write) a call. If you sell a call, the counter-party(the holder of the call) hascontrol over whether or not the option will be exercised. As the writer of the call, your payoff is equal to the premium received from the buyer of the call. However, you face losses if the security's market pricerises above the exercise price. The premium you received would partially offset this loss. But because there is theoretically no limit to how high a stock's price can rise, losses can be unlimited.
- Short put: You believe the security'sprice will increase. Yousell (write) a put. As the writer of the put, your payoff is equal to the premium received from the buyer of the put. However, you face losses if the security'smarket price falls below the exercise price. The premium you received would partially offset this loss. Your maximum theoretical loss would be if the stock's price fell to zero.
Swaps are derivatives where counterparties exchange cash flows or other variables associated with different investments. A swap occurs because one party has a comparative advantage,likeborrowing funds under variable interest rates, while another party can borrow more freely atfixed rates. Thesimplest variation of a swap is called plain vanilla, but there are many types, including:
- Interest rate swaps: Parties exchange a fixed-rate loan for one with a floating rate. If one party has a fixed-rate loan but has floating-rate liabilities, they may enter into a swap with another party and exchange their fixed rate for a floating rate to match liabilities. Interest rate swaps can also be entered into through option strategies. Aswaption gives the owner the right but not the obligationto enter into the swap.
- Currency swaps: One party exchanges loan payments and potentially principal in one currency for payments and potentially principal in another currency.
- Commodity swaps:A contract where a party and counter-partyagree to exchange cash flows, which are dependent on the price of an underlying commodity.
Parties in forward and future contracts agree to buy or sell an asset in the future for a specified price. These contracts are usually written using thespot or the most currentprice.
The purchaser's profit or loss is the difference between the spot price at the time of delivery and the forward or future price. These contracts are typically used to hedge risk or to speculate. Futures are standardized contracts that trade on exchanges, whileforwards are non-standard, trading OTC.
Frequently Asked Questions
Is an Equity Option a Derivative Investment?
Yes. Derivative investments are investments that are derived, or created, from an underlying asset. A stock option is a contract that offers the right to buy or sell the stock underlying the contract. The option trades in its own right and its value is tied to the value of the underlying stock.
Is Leverage Positive or Negative for Derivatives?
It can be either. The positive aspect of leverage associated with a derivative is that investors can acquire a large amount of value in the underlying security for a relatively small, upfront amount of capital. For instance, a Treasury Bond futures contract has a face amount of $100,000.
The initial margin required to purchase the contract is a fraction of that value (normally 3%-12%). However, the negative aspect of leverage is that if the market price of the contract drops enough, an investor would be required to deposit added capital or close out their position. This amount could be unmanageable for some.
Where Are Derivatives Sold?
Depending on the derivative, it's usually bought and sold either on a centralized exchange or through the over-the-counter (OTC) market. Some derivatives are traded on unregulated exchanges.
The Bottom Line
Investorslooking to protect or assumerisk in a portfolio can employ long,short, or neutral derivative strategies to hedge, speculate, or increase leverage.
The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a broader portfolio strategy.
