Shares of stock (like Apple’s AAPL) are valuable because of the real or potential profitability of the companies they represent. Currencies (like the US dollar or Euro) are valuable because they are backed by the governments and economies of their respective countries. Commodities (like corn, wheat, and oil) are valuable because they are useful and rely on the balance of supply and demand.
This sort of tangible valuation is direct in its nature—something has value because of that thing’s specific real-world qualities. Derivatives, on the other hand, are financial tools that also have value, but they are one step removed from this sort of tangible valuation.
The name “derivatives” comes from the fact that they derive their value from an asset like a stock or commodity, which is called the underlying asset. Functionally, derivatives are simply contracts between two parties. Those contracts specify details like how many units of the underlying asset may be exchanged, when that exchange must occur, and what is expected of each party that enters into the contract.
Based on these details, derivatives contracts have their own value that is dependent on, but not the same as the value of the underlying asset.
Why are derivatives used?
Derivatives are used for two primary purposes: hedging and speculation.
Before the markets that developed in the 20th and 21st centuries, derivative contracts were mostly used for practical business purposes. For instance, by entering into a futures contract to sell corn at $5 per bushel in three months (even before harvesting), a farm may be able to count on that income rather than worrying about pricing fluctuations in the market. It can then budget their materials and labor accordingly for the season.
For this reason, derivatives like futures and options have a long history in the agricultural industry (among others), and they continue to be used by farmers today. In fact, data from the US Department of Agriculture show that 27% of the United States’ large corn- and soybean-producing farms traded in futures in 2016. This highlights the practical use for derivatives for hedging—reducing financial risk for participants in a market.
However, hedging is also one of the main reasons that modern traders use derivatives. A good example of this is the “protective put” options contract. Because a protective put increases in value when its underlying is devalued, buying it decreases the total amount of money a trader would lose if a stock they own goes down in price—hedging their overall risk of holding the stock.
Derivatives can also be used for speculation. This is because they usually provide opportunity for traders to use leverage, allowing them to control a larger volume of underlying assets at a fraction of the cost. Although this increases potential profits, it also is a higher-risk trading strategy.
To illustrate speculation through derivatives, let’s take an example of a futures contract. An E-mini futures contract for the S&P 500 index (/ES) has a contract size of $50 x the price of the S&P 500 index. If a trader is very bullish on the market and wants to be aggressive with their trading strategy, they may buy an /ES contract. When the S&P 500 is valued at $400, the /ES contract is worth $200,000—though the trader only has to put forward a fraction of this capital through the use of margin. Using the 50x multiplier, buying one /ES contract means that if the S&P 500 increases $1.00 in value, that trader gains $50.
How do derivatives work?
There are multiple types of financial derivatives that can be traded on the market. They all have somewhat different characteristics, but there are some concepts that are common to most or all derivatives.
First, there are both exchange-traded derivatives (ETD) and over-the-counter (OTC) derivatives. ETDs are more readily available to retail traders through exchanges, like futures and options for stocks or index funds. However, many more derivative products like credit default swaps are only available—or almost entirely traded—OTC by wealthy accredited investors, large financial institutions, and hedge funds.
There is also a difference between lock and option derivatives. In lock derivative products, both parties who enter into the contract are obligated to carry out their pre-specified terms (i.e. buying or selling the underlying at a given price). Futures and forwards are examples of these. In option derivative products, the contract buyer has the right but not the obligation to buy/sell the underlying asset. The main example of such a product is named “options” for this reason.
As previously explored, leverage is also a common tool used by financial derivatives. This comes in different forms, but the main way is controlling a large number/amount of the underlying asset through one contract. Oils futures, for instance, are contracted for 1000 barrels at once. Similarly, options contracts are traditionally for 100 shares of stock.
Finally, in modern markets, settlement is usually in cash. Cash-settled delivery means that a bushel of corn or 1000 barrels of oil are never delivered to a market participants trading in derivatives—it is simply the cash value of the pre-specified amount of corn, oil, etc. that changes hands.
What are some examples of derivatives?
- Futures – A futures contract details the exchange of an asset at a specific price on a specific date, and both parties (buyer and seller) are obligated to execute their side of the contract.
- Options – Buying a call option contract gives a trader the right, but not the obligation, to buy an asset (e.g. 100 shares of a stock) on/by a given date. Buying a put option contract gives a trader the right, but not the obligation, to sell an asset on/by a given date. Buying and selling call and put contracts may be combined for various strategies for both speculation and risk management.
- Forwards – These are similar to futures contracts, but they are always OTC and thus are more customizable and variable in their terms.
- Swaps – Swaps contracts detail exchanges of cash and are based on financial considerations like varying interest rates (called interest rate swaps), currency exchange (currency swaps), and risk of default on loans (credit default swaps). These are not commonly used by retail traders.
What are the risks of trading derivatives?
The primary risk of derivative trading comes from the leverage that is involved in these strategies. Because of the large amounts of capital required to trade in derivative products, most traders must use margin through their brokers. The use of margin comes with increased risks of capital loss, as it means that traders are using borrowed funds with which to trade. This requires a skilled and educated eye to ensure appropriate risk management.
Although it is not common or relevant in the more familiar equity futures and options markets (primarily because of highly liquid brokers), many derivatives come with counterparty risk. Although on paper, a contract may require each party to fulfill their end, sometimes one of the parties is not able to do so. Financial institutions and companies entering into derivative contracts must therefore be willing to perform the appropriate research and due diligence in order to minimize this risk.
Derivatives essential
- Derivatives are financial tools that are used for speculation and/or hedging, and they are based on underlying assets like equities, currencies, commodities, and interest rates
- Examples of derivatives include futures, options, forwards, and swaps; all of these are contracts entered into by traders who accept specifications like how many assets will be bought/sold and when this exchange will happen
- Because derivative trading usually involves leverage (and margin), it can increase potential gains but also be a higher-risk trading strategy