What are they?
Derivatives are financial contracts set between two or more parties, that derive their value from underlying asset, group of assets, or benchmark. There are numerous ways derivatives can be implemented, but the overarching reasons they are used in the financial world is to hedge a position, (a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset) To increase leverage, (borrowing funds to acquire different assets to potentially lead to a profit) and to speculate on the value of an asset (the financial transaction of an asset either with the hope it will decline in value or significantly increase in value).
Who are they for?
These assets are commonly traded on exchanges or over the counter. The Chicago Mercantile Exchange (CME) is among the world’s largest derivatives exchanges. Derivatives were originally used to ensure exchange rates for internationally traded goods as international traders needed a system to account for the differing values of national currencies. Whilst derivatives are not commonly mentioned in the everyday investing world, they are not exclusive in terms of who can engage with them. Individual investors can trade derivatives through trading accounts online or through brokerage firms. Professional traders actively engage in derivative markets to profit from short term price movements and usually have specialised trading strategies. Hedge funds commonly use derivatives to continue to manage risk. Banks, commodity producers and government entities may also use forms of derivatives often to hedge against price fluctuations.
Options and Futures:
Derivatives are based on underlying asset. This means that the there are financial assets (such as upon which a derivatives price is based.) Options are an example of a derivative. An option is a financial instrument that is based on the value of underlying securities such as stocks, indexes and ETFs. An options contract offers the buyer the opportunity to buy or sell-depending on the type of contract they hold. Unlike futures, the holder is not required to buy or sell the asset if they decide against it.
Each option contract will have a specific expiration date by which the holder must exercise their option. The stated price on an option is known as the strike price. Options are typically bought and sold through online or retail brokers. Options involve a buyer and a seller where the buyer pays a premium for the rights granted by the contract
Futures on the other hand, are an agreement between two parties for the exchange and delivery of an asset at an agreed upon price at a future date. Traders can use a futures contract to hedge their risk or speculate on the price of an underlying asset. The main difference between options and futures is that with futures, the parties involved are obligated to fulfil a commitment to buy or sell the underlying asset upon its expiration date, whether it results in a profit or loss.
Types of options:
Calls: A call option gives the holder the right but not the obligation to buy the underlying security at the strike price on or before expiration. A call option will therefore become more valuable as the underlying security rises in price. A long call can be used to speculate on the price of the underlying rising, since it has unlimited upside potential but the maximum loss is the premium (price) paid for the option.
Puts: Opposite to call options, a put gives the holder the right but not the obligation to instead sell the underlying stock at the strike price on or before the expiration. A long put, is a short position in the underlying security, since the put gains value as the underlying price falls. Protective puts can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions.
Each call option has a bullish buyer and a bearish seller while put options have a bearish buyer and a bullish seller.
An example of futures at play:
For example, say that on Nov. 6, 2021, Company A buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2021.
The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy.
Buying an oil futures contract hedges the company’s risk because the seller is obligated to deliver oil to Company A for $62.22 per barrel once the contract expires.
Assume oil prices rise to $80 per barrel by Dec. 19, 2021.
Company A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.
What can they do:
Derivatives can be used to either mitigate risk (hedge) or assume risk with the expectation of commensurate (proportionate) reward (speculation). These days, they are based on a wide variety of transactions and have many more uses. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days.
The ups and downsides of derivatives:
Advantages: derivatives can be a useful tool for businesses and investors alike. They provide a way to do the following
- Lock in prices
- Hedge against unfavourable movements in rates
- Mitigate risks
Disadvantages: hard to value because they are based on the price of another asset. The risks include counterparty risks that are difficult to predict. They are sensitive to the following:
- Changes in the amount of time to expiration
- The cost of holding the underlying asset
- Interest rates
Derivatives as a concept may seem intimidating or confusing. However, it is most important to remember that they are just a way of attaining a more sort after outcome financially. It is not crucial that derivatives are used for financial prosperity, either. Actually, it is far from it. See the attached link to a clip of Warren Buffett speaking on derivatives at Berkshire and take it from the best.
https://youtube.com/shorts/hss6yKyIPGU?feature=shared