“Derivative” is an umbrella term that refers to any kind of financial security that derives its value from another asset. A derivative exists as a contract between two parties, and its value fluctuates in direct relation to its underlying asset. Some of the most commonly used assets that derivative contracts focus on include commodities, stocks, bonds, and currencies.
Futures and options contracts are examples of widely known derivatives. Credit-default swaps (CDS) are a lesser used, and riskier, form of derivatives, since they’re traded off of exchanges and the contract parties in that case do not own the underlying asset.
What Is a Trading Derivative?
A trading derivative is any contract that derives its value from an underlying asset. The nature of the relationship between the derivative and the underlying asset varies depending on the type of derivative.
Investors engage in trading derivatives for three main reasons:
• to hedge a position
• to gain leverage on a position
• to speculate on the future price of an asset
They’re a common tool for institutional investors, and also often used as a day trading strategy.
💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.
Types of Derivatives
Here are a few examples of different kinds of derivatives and how they work.
Options
An option gives the owner the right (but not the obligation) to buy or sell an asset at a certain price in a specific timeframe. Savvy investors can use options to make a profit regardless of whether the market is going up or down.
The two most basic types of options are call options and put options. Call options give the owner the option to buy an asset at a specific price over a set time frame, while put options give the owner the right to sell an asset at a specific price over a set time frame.
The two main aspects of a put or call option are the strike price and the expiry date. The strike price is the price at which the owner intends to buy or sell the security, and the expiry date is the date by which the option must either expire or be exercised. Employee stock options are one type of derivative, in which the employees can (but do not have to) purchase shares of their company in the future at a price set today.
There are also many complex options trading strategies that include multiple “legs,” or multiple options contracts on the same underlying security. Some investors use “naked options,” which are a riskier form of option, in which the trader does not own the underlying security or have cash set aside to meet the obligation at expiration.
Futures Contracts
Often referred to simply as “futures,” futures contracts represent an obligation between a buyer and seller to exchange an asset for a fixed price on a selected date. Most futures trades take place on large exchanges and involve commodities such as oil, soybeans, or copper.
Farmers have used futures since the 1850s to reduce investment risk over future price fluctuations for their crops. Today, futures exist for many commodities and financial markets. These derivatives are mostly used as a form of speculation, where traders seek to make a quick profit.
Futures are sold on stock exchanges and have a standard form regulated by the U.S. Commodity Futures Trading Commission (CFTC).
Forward Contracts
Forward contracts are similar to futures contracts. But unlike futures, forward contracts are customized between the two parties entering into an agreement, as opposed to being standardized by regulators. Forwards are over-the-counter (OTC) derivatives and are not traded on exchanges. This market is private and unregulated.
Is Derivative Trading Profitable?
Derivatives tend to have high investment risk, but also offer high potential rewards. Large profits can be made quickly, but bets can go bad just as easily.
Depending on how they’re used, derivatives can range from simple speculation to being an integral part of an advanced, sophisticated strategy that incorporates many different types of investments.
Derivatives trading is especially risky for new investors who might not understand the bets they are making. Derivatives contracts involve many more variables than simply buying shares of a stock, and placing trades on an exchange can be confusing.
💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.
What Is a Derivative Trading Example?
Imagine an investor has their eye on a particular stock that they think will rise in price soon. One way to profit would be to buy shares. Another way would be to buy a derivative, such as a call option.
Our imaginary investor decides to buy a call option contract on ABC company. The strike price could be ten dollars higher than the current price, while the expiry date could be three months from now.
This could create a profit for the investor in two possible ways. The stock price could rise above the strike price of the call option, at which point the investor can sell the contract for more than it was purchased for.
Or, the investor can wait for the expiry date to come, at which point she will receive shares of the underlying stock at a price lower than their current market value.
How Are Derivatives Valued?
On the most basic level, the market values derivatives according to simple supply-and-demand dynamics as well as variables specific to the option itself, i.e. strike price and expiration date.
An options contract, for example, might be worth whatever people are willing to pay for it. This can change quickly and sometimes dramatically based on market conditions and news. Investors consider an option “out of the money” if its strike price is lower than the market price of the underlying asset.
On a more advanced level, investors can determine what the actual value of a derivative should be, as opposed to its current market value at any given moment.
One method for valuing derivatives is the Black Scholes model, a mathematical formula for determining market value for European call options. This formula takes into account several variables such as the implied volatility of an option, time left until expiration, and the present value of the option.
How Can Derivatives Be Used to Earn Income?
Investors use a variety of derivatives trading strategies. One common approach is a cash-secured put.
This derivatives trading strategy involves selling an out-of-the-money put option while also putting aside the money necessary to buy the underlying stock if it falls to the option’s strike price. The goal is typically to acquire shares of the stock at a price lower than it is trading at today, but investors also earn income in the form of a premium.
A premium is the price an investor pays for acquiring an options contract. Premiums are determined by the relationship between the underlying stock price and the strike price of the option, the length of time until the option expires, and how much the price of the stock fluctuates.
A premium of $0.20 per option contract, for example, would amount to $20 per contract, if one options contract represents 100 shares ($0.20 x 100 = $20).
So, if an investor were to place a cash-secured put with a strike price of $40 for a stock that currently trades at $50, they would need to set aside $4,000 and sell (or “write”) the associated put option.
Recommended: Guide to Writing Put Options
Then, if the price falls to $40 before the expiration time, the investor would buy shares at that price and keep the premium. Or, if the price doesn’t fall to the $40 level, the option will expire, worthless, and the investor will also keep the premium.
The Takeaway
Derivatives trading strategies provide a more advanced way to trade and speculate in the markets, earn income, or hedge a portfolio. Derivatives trading is more complex than simply buying and selling securities, comes with greater risk, and can potentially earn greater rewards. It’s common in certain sectors, such as precious metals or currency trading.
Given their complexities, derivatives may not be the best focus for beginner investors. They are complicated and risky, and it’s easy to find yourself in over your head. It may be a good idea to talk to a financial professional if you do want to explore your options, however.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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