Editor's Note: Options are not suitable for all investors. 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. Please see the Characteristics and Risks of Standardized Options.
Table of Contents
A derivative is a secondary security, meaning it is not an asset itself but rather a contract that tracks the value of an underlying asset, such as stocks, commodities, foreign currencies. A derivative is so named because it derives its value from the underlying asset.
Derivative contracts are a legal financial agreement between two parties: a buyer and seller. Common types of derivatives include options, futures, swaps, and forward contracts.
The value of these derivatives fluctuates based on market events, changes to the underlying price, and other factors related to the underlying asset.
Experienced investors often use derivatives to place bigger bets, to help hedge their investments against future loss, or to try to profit from upcoming market shifts. Some investors also use them to profit or speculate on commodities, such as gold or oil. They can serve different purposes for different people, such as limiting risk related to possible future events.
Key Points
• Derivatives are financial contracts that derive their value from underlying assets such as stocks, bonds, commodities, and more.
• Derivatives are typically traded using leverage (i.e., margin).
• Options, futures, and swaps are common types of derivatives, each with unique features and purposes.
• Derivatives are used for hedging (to manage risk), and for speculation to try to profit from market movements.
• Trading derivatives involves significant risks, including potential for steep losses.
• Potential advantages of derivatives include leverage, flexibility, and the ability to hedge against market volatility.
How Does a Derivative Work in Finance?
A derivative is a legally binding contract that can take the form of futures, swaps, and options trading. A derivative contract outlines the terms, rules, and costs for a potential future transaction based on the performance of an underlying asset.
For instance, if an investor decided to buy stock and has a significant amount of a particular stock with an unrealized gain, they might choose to enter into a derivative contract that gives them the ability to sell it at a specific price on a future date. This may provide them with some protection against future losses.
Derivatives are also a way to give investors exposure to a certain asset class without having to actually buy the assets, when investing online or through a traditional brokerage.
In addition: Derivatives are leveraged contracts, in that the investor pays a fee that’s a fraction of the total cost to control the underlying position. The seller of a derivative doesn’t always need to own the underlying asset. In many cases, the buyer never owns the asset directly either. Derivatives provide exposure to the asset’s value rather than trading it directly.
Derivative Example
A derivative contract, such as a call option, would grant the option buyer the right, but not the obligation, to purchase shares of a particular stock at a predetermined price of, say, $150 per share (the strike price) within a six-month period (the expiration).
The standard options contract is for 100 shares of stock.
The appeal of this strategy, and the appeal of derivatives in general, is that the buyer is able to purchase the right to buy the underlying asset at the strike price, on or before the expiration — but only pay the cost of the contract, which is the premium. If the trade moves in the wrong direction, they are not obligated to buy the underlying shares.
In other words, options (like other types of derivatives) enable investors to make bigger trades than they could with just cash.
Recommended: Options Trading 101
Types of Derivatives
There are two categories of derivatives: obligation-based contracts and option-based contracts. Obligation-based contracts include swaps and futures. These form an obligation between both parties to fulfill the terms of the agreement.
Option contracts give the parties the right, but not necessarily the obligation, to fulfill the contract transaction.
Options
Options are a common type of derivative that give traders the right, but not necessarily the obligation, to buy or sell an underlying asset at a predetermined price within a set time frame. Since the value of an option contract depends on the price movements of the underlying asset, it’s considered a derivative.
Traders use options for speculation or to hedge against potential losses, but they carry risks, including the possibility of losing the premium paid upfront (for buyers), and the potential for significant losses, particularly for uncovered (naked) option sellers.
Recommended: Popular Options Trading Terminology to Know
Futures
With futures contracts, the buyer and seller set a price to buy or sell an asset or commodity on a specific date in the future. The contract includes the price, the amount, and the future settlement date. The contract obligates both parties to fulfill the contract.
Traders are required to deposit margin funds, which is a fraction of the contract value. They may also need to post additional funds, known as maintenance margin, to cover potential losses.
Once the contract is entered into, the price of the underlying asset is tracked daily, and any gains or losses are added to or removed from the trader’s account until the contract is sold or expires.
Futures contracts are traded on regulated exchanges, while similar contracts, known as forwards, are sold over the counter (OTC), allowing for more negotiation but less regulatory oversight and greater risk exposure.
Swaps
Swaps are contracts traded OTC for the exchange of financial terms or cash flows such as interest rates and currencies.
Companies can swap types of interest rates in order to get better terms. Often, one rate is variable and the other rate is fixed.
With currency swaps, companies can invest overseas with a lower risk of exchange rate fluctuations.
What Is Margin?
Margin requirements for derivatives trading differ somewhat from standard margin trading in stocks.
In futures trading, traders must deposit an initial margin, which is a fraction of the total contract value, to open a position. They may also need to post maintenance margin to cover potential losses if the trade moves against them.
In options trading, margin requirements depend on whether an investor is buying or selling an option. Buyers pay a premium upfront, while sellers (writers) may need to post margin to ensure they can fulfill their obligations if the option is exercised.
Swaps may also involve margin requirements, particularly in over-the-counter markets, to mitigate counterparty risk. The specifics vary based on the contract terms and the regulatory environment.
How Derivative Trading Works
A derivatives contract says that the investor will either earn or pay money related to the underlying asset. Although there is an initial cost for the derivative contract, traders may be required to contribute additional maintenance margin if the underlying asset moves against their position.
Once a derivative contract is entered into, the buyer can either hold onto it until the expiration date when they purchase the asset at the agreed upon price, or they can sell the contract to someone else, potentially for a profit. Trading one derivative for another one prior to the contract end date is common.
Generally the contract will sell for only a tiny amount of the value of the underlying asset, but the value of the contract can fluctuate along with the underlying asset price fluctuations — and as the expiration date draws closer.
There is a small initial deposit, sometimes called a premium, required to enter into the contract. This amount varies depending on the type of derivative and market conditions. For example, there could be a contract to purchase 100 shares of a stock for $300 per share, and the option contract might trade at a premium of $3 per share.
Before entering into a derivative contract, it’s important to understand how derivatives work and read what the contract entails, including the disclosure statement. There will be an agreement to sign stating that both parties have read and understand the terms.
Trading derivatives also requires ongoing work and attention. Markets can change quickly, and there may be obligations throughout the contract period, such as tracking the value of the underlying asset.
Costs
Derivative contracts come with various costs depending on the type of contract and the market where they are traded. Common costs include:
• Options: Premiums, commissions, and potential assignment fees
• Futures: Initial margin, maintenance margin, and exchange fees
• Swaps and Other OTC Derivatives: Transaction fees and counterparty costs
Derivatives are best suited for experienced investors who understand the potential risk of loss involved. Consider consulting with a financial professional to understand the full costs for specific trades.
Pros and Cons of Trading Derivatives
There are several pros and cons to trading derivatives. Some of the main ones are:
Potential Benefits
Derivatives traders may benefit from potential upsides, including:
• A hedge against the risk of future losses
• An opportunity for speculation
• Exposure to an asset without having to purchase it
• Can help predict future cash flows
• Provides the ability to lock in prices
Potential Risks
In addition to the advantages, there are several potential drawbacks that derivatives traders should understand.
• Trading derivatives is very complex and can be risky for inexperienced traders
• The derivative contract may not be liquid or easily sellable on the open market
• There is a risk of losing more than you invest
• Online scams in derivatives trading are common, adding to the risk
• There are fees and costs associated with the contract
• There may be ongoing maintenance and time commitment required
Financial Derivatives Regulations
Regulations around derivatives vary depending on where they are traded. The Securities and Exchange Commission regulates derivatives traded on registered national securities exchanges, while over-the-counter (OTC) derivatives — which are the majority of derivatives — are typically subject to less oversight and may involve bilateral agreements between parties.
In the latter case, the parties negotiate the terms of contracts on their own. Sometimes these parties include banks and financial institutions regulated by the SEC.
Futures brokers and commercial traders must be registered with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC).
The Chicago Board Options Exchange (CBOE) is the most well known options exchange platform and is regulated by the SEC. These regulating bodies help to prevent fraud and abusive trading practices and promote fair, orderly markets.
The Takeaway
Derivatives can be a riskier type of investment but they can provide value to both institutional and retail investors’ portfolios when used appropriately, and with a clear understanding of the risks involved.
Trading derivatives requires more work than simply buying and selling more traditional securities, chiefly owing to the representational nature of a derivative contract (i.e., you’re not trading the asset directly) and the use of leverage.
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FAQ
What are derivatives in simple terms?
Derivatives are contracts that represent a certain amount of an underlying asset (e.g., stocks, commodities, a benchmark index). Investors can pay a relatively small amount to purchase a derivative such as an options contract, which they can then trade.
What are the four main types of derivatives?
The four main types of derivative contracts are options, futures, swaps, and forwards. These contracts represent different types of sophisticated, higher-risk investing strategies. Less experienced investors may want to do their due diligence before trading derivatives.
Are derivatives a type of alternative investment?
Derivative products can be used in some alternative strategies, such as hedge funds, but they aren’t considered alternative assets in the same way that, say, commodities, private equity or real estate are. Many derivatives, such as options and futures, are highly regulated, and many derivative contracts are tied to traditional underlying assets such as stocks. That said, the majority of derivatives are traded over-the-counter, making them less liquid and less transparent and more like alternatives.
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Before investing, carefully consider the investment objectives, risks, charges, and expenses detailed in a Fund’s prospectus. This document contains important information and must be read carefully prior to investing; you can find the current prospectus by clicking the link on the Fund’s respective page.
Alternative investments are highly risky and may not be suitable for all investors. These investments often involve leveraging, speculative practices, and the potential for complete loss of investment. They typically charge high fees, lack diversification, and can be highly illiquid and volatile. Be aware that both registered and unregistered alternative investments, including Interval Funds, are not subject to the same regulatory requirements as mutual funds, and their illiquid nature may restrict your ability to trade on your timeline. Always review the specific fee schedule for Interval Funds within their prospectus.
Options involve substantial risk of loss and the possibility an investor may lose the entire amount invested. Before starting options trading, investors should be familiar with the Characteristics and Risks of Standardized Options . TTax implications with options should be considered. Consult your tax advisor to understand any impacts to your taxes.
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