Derivatives

What Are Derivatives?

Derivatives are a class of securities whose price is dependent upon the price of an underlying asset. Underlying assets that spawn derivatives include stocks, bonds, commodities, market indexes, currencies, loans, and interest rates.

If you buy stock in a company, you own a certain number of shares in it, which do have a certain market value. This depends on what others will pay for it if you look to put your ownership of these shares on the market, where you’d be looking to transfer ownership of the stock in exchange for a certain price.

Instead though, you may choose to buy an option to purchase these shares at a later date. All securities need an issuer, the company itself issues stock which is then bought and sold, and this is the case with all securities trades that trade assets, there is an asset involved that is being traded.

Since derivatives don’t involve trading in assets but are instead contracts to trade assets, derived from the assets, derivatives are contracts between investors so to speak, between those who hold a position in the asset or who could hold a position in the asset as required by the contract.

Short selling is kind of like trading in a derivative, and this is when someone borrows stock from another investor through a broker, sells it in the market and promises to buy it back to return to the initial owner, hopefully paying less for it than it was sold for and realizing a profit.

This does involve trading in the underlying security, on both ends of the trade, and derivatives may involve trading the asset at one end but never at both. What is involved with a derivative contract is a promise to execute a future transaction, and derivatives always involve future transactions, and therefore the future price of something will always be involved.

The Long and the Short of It

The difference between a long and short position in trading stock will be important to understand when it comes to trading derivatives, because, like stocks, they do involve both long and short positions. So if you look to buy an option to buy a stock at a later date at a certain price, someone is promising to buy it to sell it to you, called the writer of the option, and so there’s always two sides to every trade, and the options writer provides the other side.

So that’s really the main difference between traded assets and derivatives, with traded assets, some sort of asset is always being traded, while with derivatives, someone is providing the opportunity to execute the derivative contract by taking the other position on it.

If trading in financial securities is to be seen as placing bets on things, and for the most part that’s exactly what it is, then trading in derivatives involves market participants making side bets between themselves on the outcome of the performance of securities.

What makes derivatives particularly interesting is that you can place bets either way on an underlying security, betting either that it will go up or go down, and since this is not based upon the ownership of anyone at the time of the trade, there are no restrictions on this, like there are with short selling stocks for instance.

Much of the derivatives market occurs over the counter, meaning not through an exchange, and therefore is unregulated. Over the counter means that traders trade directly with one another and not through a third party who manages it, like a financial exchange. Some derivatives are exchange traded through, and the fact that a trade isn’t performed through an exchange isn’t necessarily a big reason for concern, and is actually more efficient.

With derivatives, you can not only take a position long or short, you can write the contracts as well so to speak. So let’s say someone wants the option to buy a stock in the future at a certain price. If you sell them the contract, you may be obligated to buy it at that price for them at that date should they decide to execute the option, and they will pay a premium to you in order to have the right to do so. If the stock doesn’t hit the strike price, then it won’t be exercised, and you keep the premium paid, but if it does, you are on the hook for the difference in the price you paid and the price you must sell the option buyer.

Why Do People Trade in Derivatives?

Derivative contracts are written in this way so to speak, created out of nothing other than side bets on the future price of things, or even on future outcomes such as how much rain a certain area will receive. So there’s no limit on what can be bet on here, and people actually do bet on the rain, but not just to gamble, but as a hedge on future positions they may hold in the commodities market, to look to limit their risk.

Hedging positions is the fundamental reason behind the derivatives market, where someone is looking to hedge their risk with the underlying asset traded. In the case of weather related derivatives, someone is worried about a lack of rain affecting the price of a commodity that is dependent upon it, corn for instance, and provided someone is willing to take their bet so to speak, if they bet on less rain and it happens, the price of the futures contract will decline, but their losses will be somewhat offset by winning the bet on the weather.

The futures contract itself is a type of hedge, for instance people may want to either buy or sell a commodity at a certain price down the road, to reduce the risk involved in holding it. Since all trades require two sides to it, we could not really rely on hedgers betting against hedgers, since hedging would usually involve the same side of the bet.

So this is where the other side of derivatives comes in, the speculator. We do need speculators to make derivative markets work, and this is people who have no essential interest in the underlying assets other than simply looking to make a profit from trading in the derivatives. Some derivative trades also occur between speculators, although in many cases there will need to be someone who needs to take possession of the asset, if the contract is exercised.

Speculators may trade in derivatives though with no intention of ever taking possession of the underlying assets, for instance they may buy a stock option with the intention of selling it prior to the exercise date, with the pure intention of making a profit. The seeking of profit is what distinguishes speculators actually, where hedgers are instead looking to reduce their risks.

From a personal finance perspective, one may both look to hedge positions with derivatives and also look to speculate, although speculating in derivatives tends to be riskier, more volatile in other words, then hedging, or even speculating in underlying assets, which tend to be more stable.

Types Of Financial Derivatives

There are several form of derivatives, and derivatives are simply a class of investments, those whose value is derived from the price of something else.

Futures contracts are a form, as they are based upon the value of something in the future. Let’s say someone owns an asset or expects to own it at some future date. Let’s say they paid a certain price and didn’t want it to go down, or didn’t want it to go down below a certain amount.

So they could enter into a futures contract with someone who would agree to purchase the asset at that point in time for an agreed upon price. The owner of the asset would pay a premium to the future purchaser for this service.

In this instance, if the value of the asset is below the agreed upon price less the premium, the original holder has benefited, as they would have sold the asset for less than they paid for it plus the premium had they not entered into the contract. If not, the new purchaser benefits, by buying the asset at a lower cost than the price of the contract less the premium.

So this all involves speculating on the future value of something, this is why it’s called the futures market. Options are similar to futures, but in the case of options, they involve a right but not an obligation to exercise the contract by the person who holds it at expiration.

There are several different types of options, and several ways to trade in them as well. One may purchase a right to buy something, called a call option, and one may also purchase the right to sell something, similar in a lot of ways to short selling, called buying a put option. One may also sell call options and put options, taking the other side of the trade, write the option, and one may or may not possess the underlying security, and when they don’t, that’s called naked option writing.

There is a type of options trade that does not ever involve taking possession of anything, called binary options, and this is simply a bet for and against an outcome, whether an underlying asset will be at or above a certain price for instance. This is an all or nothing bet so to speak, you either win or you lose the entire value of the contract.

Other types of derivatives include forward contracts, which are similar to futures but are not regulated by an exchange, interest rate swaps, involving trading interest rate terms, such as swapping variable rate interest for fixed rate interest, and credit swaps, like for instance mortgage backed securities that were so prominent in the media during the recent mortgage crisis.

While most derivatives are traded over the counter, between investors so to speak, exchange traded derivatives have become very popular with individual investors due to the advantages of the securities being traded on exchanges, who can exercise some control over the process and reduce or eliminate some risks, such as the risk the other party may default.

Derivatives can serve as a mechanism to hedge positions and reduce risk, or they can be used for pure speculation. One must account for the additional risk involved in speculating in things like futures and options, which can be significantly higher than traditional investing, although the rewards can be significantly higher as well.

Derivatives FAQs

• What is derivatives and types of derivatives?
  Financial derivatives are securities that depend on another asset to derive its value. This may involve the present value of another instrument as we see with mortgage-backed securities, the future value of something as we see with futures contracts, or an option to buy something in the future that options trading involves.
• What is a derivative in accounting?
  Accounting involves placing certain values on assets. With derivatives, since you do not enter into a direct transaction with the asset and only are involved in a secondary transaction based upon the value of these primary transactions, this may require derivatives to be treated differently from an accounting perspective, where their value is more projected.
• What is an OTC derivative?
  Financial securities are either traded on an exchange or OTC, which stands for over the counter. OTC derivatives are traded directly between parties with brokers acting as intermediaries. OTC derivative contracts are highly customizable although they do involve counterparty risk where the other party may not fulfill their obligations.
• What is derivative example?
  Futures contracts are a well-known type of a financial derivative, where parties enter into a contract to exchange a certain good in the future. This allows those who are selling the commodity to lock in the price they will sell it at later as well as buyers doing the same with the price they will pay in the future.
• Are derivatives dangerous?
  There are some who see certain types of derivatives as very dangerous, and they can be, but the danger is not that the derivatives are traded, it is when they are traded without enough transparency so that the risks are not understood properly. An example would be with the collateralized debt obligations crash of 2008.
• How do derivatives work?
  The best way to understand derivatives is to see all investing as making bets on the future value of an asset, where derivatives involve placing side bets between parties on the future value of these assets. An options contract is a good example of this where people bet on the future value of the asset the option is on.
• How are derivatives traded?
  Derivatives can either be traded on exchanges or over the counter. Exchange trading involves and requires that what is being traded is standardized, like futures contracts are. The exchange clears the trade and reduces the risk the trade won’t clear properly. Derivates are also traded as private contracts, called over the counter trading.
• What is swaps and its types?
  Swaps involve the exchange of income flows and risks between parties. Interest rate swaps are the most common, where banks exchange fixed and variable rate debt. There are several other types of swaps, including credit default swaps, asset swaps, commodity swaps, foreign exchange swaps, trigger swaps, and total return swaps.
• Why are derivatives used?
  The main function of derivatives is to allow for a more efficient transfer of risk from a party who holds the risk to another who is willing to take it on. Derivatives both reduce the risk of holding financial assets by placing it in the hands of those who are better able to bear it, as well as adding a lot more liquidity to the markets they serve.
• Are Warrants derivatives?
  Warrants are a type of option where the owner has the opportunity to exercise the warrant and buy a security at a certain price if they wish to do so. Since the existence of the warrant depends upon something else, in this case the security that the warrant is held on, it is indeed a derivative.
• What are listed derivatives?
  Listed derivatives are derivatives that are listed on and traded on exchanges rather than just between parties and their brokers. Futures contracts are a good example of a listed derivative which can be bought and sold on futures exchanges. If the parties wish to put together a custom contract, these are called forward contracts and are traded directly.
• What are options derivatives?
  Options derivatives are options to buy or sell an asset in the future, where one side pays a premium for the opportunity but not the obligation, which is why it is called an option. The option holder may profit from this, and the options writer who takes on the other side of the options trade bears the risk of losses should the other person profit.
• How do derivatives reduce risk?
  Derivatives reduce risk by allowing for principles in financial transactions to reduce their risk by assigning it to other parties who are more willing and able to bear it. This works similar to buying insurance where you cannot bear a certain fate so you assign it to an insurance company who can handle it much better and you pay a premium for this.
• What are the benefits of derivatives?
  The main benefit of derivatives is that it allows for more hedging than would be possible without them. Producers and users of commodities can therefore lock in future prices and conduct their businesses more efficiently. Derivatives also provide a lot more liquidity to markets and also offer a lot more trading opportunities.

References & Scholarly Articles for Derivatives

• Derivatives: A Twenty-First Century Understanding
• A Normative Analysis of New Financially Engineered Derivatives
• Usage of Derivatives in Business Today

Books on Derivatives

• All About Derivatives (Author: Michael Durbin, Originally published: August 24, 2005)
• Derivatives Essentials: An Introduction to Forwards, Futures, Options and Swaps (Author: Aron A. Gottesman, Originally published: June 28, 2016)
• Derivatives The Wild Beast of Finance: A Path to Effective Globalisation? (Author: Alfred Steinherr, Originally published: June 15, 1998)

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.