What is a Derivative?
Everything you need to know about derivatives: types, strategies, and risk management.
š everyone,
OK, so Iāll admit Iāve been hibernating a little longer than anticipated this winter and this is my first post of the year so apologies for that. Butā¦ now Iām back with a regular cadence and Iām starting off with a bang in terms of financial concepts that leave folks bewildered:
Derivatives.
If youāre new to the world of finance, I totally appreciate if you just shuddered when you read that word and thought āno thanks, not for meā.
But hang on for a moment and let me explain. Thereās a few potential pros as a regular everyday investor (or would-be investor) to knowing about the ins and outs of derivatives, so letās dive in and I promise you itās not as tedious as you may think.
Today I'll cover:
What are derivatives? A quick explanation ā”
Why do derivatives exist?
š§ Common strategiesĀ
Derivative risks and considerations
š¹ explanation
An example of derivatives in action
Key terminology you need to know
š ļø Useful tools for further exploration
Quickly Explained
Derivatives are financial tools whose value is intricately tied to another entity known as the underlying asset. In simpler terms, the worth of derivatives is derived from the performance of the underlying instrument, which can include stocks, bonds, currencies, interest rates, commodities, and more.
Individually, derivatives hold no intrinsic value. Instead, their value is contingent upon and influenced by the fluctuations in the price of the underlying asset. Essentially, the value a derivative is closely intertwined with the movements and changes in the value of the assets they are linked to.
In this sense, a derivative is a bit like a bet.
For example, let's say you believe that the price of Company X's stock will rise in the future. Rather than buying the actual stock, you can purchase something called a derivative contract (such as a call option) that gives you the right, but not the obligation, to buy the stock at a predetermined price.
Make sense š¬?
If this still doesnāt make any sense, letās also explore an imaginary real world example that isnāt linked to finance. Imagine you're a farmer who grows apples, and you're planning to sell your harvest at the local farmer's market in three months. However, you're worried that the price of apples might go down by the time you're ready to sell, which could reduce your profits. On the other side, there's a juice maker who needs apples for their juice production and is worried that the price of apples might go up, increasing their production costs.
Here's where a financial derivative, specifically a futures contract, comes into play:
Agreement: You and the juice maker enter into a futures contract. This contract is an agreement to buy/sell the apples at a predetermined price on a specific future date. Let's say you both agree on a price of $5 per bushel of apples to be sold/bought in three months.
Contract expiry: When the contract expires in three months, the agreed transaction must be completed at the set price, regardless of the market price. If the market price is higher than $5, the juice maker benefits because they are paying less for the apples than the market rate. If the market price is lower, you benefit because you are selling your apples for more than the market rate.
A derivative is a bet on whether a stock, or a bond or a real estate asset, is going to go up or down. There's a winner and a loser. It's like betting on a horserace.
Michael Hudson
Types of derivatives
Derivatives are a category which include various different types that are available to investors. The most common types of derivatives include: futures contracts which allow investors to buy or sell an asset at a predetermined price in the future, options which give the buyer the right (but not the obligation) to buy an asset at a price before a certain expiry date and swaps, where two parties agree to exchange cash flows or other types of instruments.
More on these terms later.
Why Do Derivatives Exist? š¤·š»
It might seem odd that financial markets have such a thing as derivatives. After all, why not simply trade the underlying asset itself? Well, derivatives serve several purposes:
Risk Management: In an unpredictable financial world, derivatives act as shields, allowing businesses and investors to manage and reduce risk. They can use derivatives to hedge against adverse price movements, securing themselves against potential losses.
Leverage: Derivatives provide a way to amplify gains or losses by controlling a larger position with a smaller investment. This leverage can be both an advantage and a danger, depending on how it's used. PS if you want a refresher on leverage, this guide on financial leverage should help.
Speculation: Derivatives arenāt just handy for risk mitigation. Many traders use derivatives to speculate on price movements without owning the actual assets. Stakes are high as this speculation can lead to profits if their predictions are correct but can also result in losses if they're wrong.
š¹ Derivatives explained in under 60 secondsā¦
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š§ Common Strategies
Based on financial goals, there are a variety of different strategies when it comes to trading derivatives. Here are some of the most common:Ā
Hedging: Use derivatives to protect your existing investments from potential losses due to market fluctuations. It's like buying insurance for your portfolio.
Speculating: Take positions in derivatives based on your market predictions. If you believe a stock will rise, you can buy a call option, potentially profiting from the price increase. Itās like betting on a company you believe in.
Arbitrage: This strategy involves exploiting price discrepancies between related assets in different markets. Arbitrageurs aim to make a profit from these differences e.g. buying a stock at a lower price on one exchange and selling it at a higher price on another.
Risks and Considerations š
While derivatives offer a range of benefits that make them attractive to investors and businesses, they are not without risks. Here are some important considerations:
Leverage Risk: Leverage can amplify both gains and losses. Itās best to ne cautious when using leverage, and only trade with capital you can afford to lose.
Market Volatility: Derivative markets can be highly volatile. Prices can change rapidly, so it's essential to stay informed and have risk management strategies in place.
Counterparty Risk: When trading derivatives, you're making agreements with other parties. Ensure you're dealing with reputable counterparties to minimise the risk of default.
š terminology you need to know
The world of derivatives on the surface may seem complex, so letās breakdown some key terms:Ā
Futures: Derivative contracts obligating the buyer to purchase, and the seller to sell, the underlying asset at a predetermined price and date.
Options: Contracts that give the holder the right (but not the obligation) to buy (call option) or sell (put option) an underlying asset at a specific price within a specified period.
Swaps: Agreements between two parties to exchange a series of cash flows based on predetermined conditions. Common types include interest rate swaps and currency swaps.
Leverage: The ability to control a larger position with a smaller amount of capital, magnifying both gains and losses.
Derivative Markets: Financial exchanges where derivative contracts are bought and sold.
An example
OK, now let's explore derivatives in with an actual example. Imagine you want to speculate on the future price of gold. Instead of buying gold bars, you can enter into a gold futures contract.Ā
Here's how it works:
š°Current Gold Price: $1,800 per ounce
Gold Futures Contract: Expires in three months
If you believe the price of gold will rise, you can buy a futures contract at the current price of $1,800 per ounce. If, after three months, the price of gold has risen to $1,900 per ounce, you can sell your futures contract, earning a profit of $100 per ounce.
However, if the price falls to $1,700 per ounce, you would incur a loss of $100 per ounce. This hopefully demonstrates how derivatives can magnify gains and losses based on your predictions.
š ļø Useful Tools
And when it comes to derivatives, here are some tools you might find helpful:
Derivative Pricing Calculator: this helps you estimate the value of derivative contracts based on various factors. It can assist you in evaluating the potential outcomes of your derivative trades.
Options Strategies: Learn about different options strategies, from covered calls to straddles. Understanding these strategies is important to make informed decisions when trading options.
Futures Market Resources: Stay updated with the latest news and trends in the futures market. Access reputable financial news websites to stay informed about market developments.
Thank you very much for reading š if you found this helpful and enjoyed the post, Iād be super grateful if you could hit the ā¤ļø below - thank you!
DISCLAIMER: None of this is financial advice. Concepts of Finance newsletter is strictly for educational purposes.
Thanks Jason, super helpful as always! And welcome back š