Derivatives are a financial asset based on a contract and an underlying asset. The value of the derivative is derived from the underlying asset.
What is a derivative?
A derivative is a financial instrument based on another asset. The most common types of derivatives, stock options and commodity futures, are probably things you’ve heard of but might not know exactly how they work.
Derivatives generally give a user the right, but not the obligation, to buy or sell an underlying asset at some point in the future. The value of the derivative is based on the underlying asset and the time until the contract expires. Let’s take a look at why you would trade derivatives, what the common types are, and their pros and cons.
Why trade financial derivatives?
Billions, even billions of dollars of derivatives are traded every year. Investment accounts ranging from the teen level on an app with birthday money to mega-corporations use derivatives for each of the reasons we’ll discuss.
Coverage is commonly used by businesses, but can also be used by individuals. You may know Southwest Airlines‘ (NYSE: LUV) famous jet fuel hedging program of the early 2000s. As other airlines lost money due to rising fuel prices, Southwest’s hedging kept it making money.
When you hedge, you are making a small bet against your primary position. Southwest’s core business requires a lot of investment in jet fuel, so it has used derivatives to make a small bet in case prices rise. Since derivatives are often heavily leveraged (see next section), you don’t need to bet so much on the derivative to cover your entire investment.
As an individual investor, you can hedge if you are concerned that any of your favorite stocks (or the stock market as a whole) is overvalued. At The Motley Fool, we recommend a long-term buy and hold strategy, but sometimes it is difficult to handle a lot of volatility.
Derivatives allow you to take control of a large amount of assets with a not-so-large investment. Take a look at this purchase option for Home deposit (NYSE: HD):
Home Depot’s stock price is around that $ 330 strike price, but the price of this option is only $ 12.84. If the Home Depot share price hit $ 340, the option price would likely rise by about the same amount (it wouldn’t exactly replicate the jump for reasons we won’t go into in this article).
By investing $ 12.84, you can get gains on stock price movements of $ 340. Of course, the reverse is also true. A $ 15 drop in Home Depot’s stock price wouldn’t matter much to shareholders, but it would totally wipe out your position.
Access to assets
Investors also use derivatives to access assets that they might not otherwise be able to trade. You might want to hedge your Southwest Airlines market position by buying oil, but you’ll be hard pressed to store enough barrels in your yard to make it worth it.
Instead, you can gain exposure to these asset classes through futures or, better yet, exchange traded funds (ETFs) that buy futures for you.
When you buy a stock, you buy the same stock as everyone else. You have the same right to winnings and the same vote as all other members of your share class. Derivatives can be more personalized.
Most derivatives traded on exchanges are just as homogeneous as stocks, but super-investors and corporations often look to investment banks to create custom derivatives to use for specific transactions. Many famous investors who bet on the collapse of the real estate market in 2007 have used derivatives created especially for them by investment banks.
Many investors sell derivatives to earn income. For example, if you own a stock and don’t expect its price to rise significantly in the near future, you could sell an option to someone who owns one. If the stock doesn’t go up, you keep the option price. This is the covered buy strategy.
Types of derivatives
We have mentioned futures and options as common types of derivatives. Here’s how these work and a few other common types of derivatives.
A futures contract is an agreement to buy or sell an asset at a future date. Let’s say you are a corn farmer and you know you will have 5,000 bushels of corn to sell in October. Right now it is May and you need to set your price for financial planning.
You agree to a futures contract to sell the corn at a fixed price in October (the future). The buyer may be worried about the price of corn rising and their investments being hedged, or they may even be a speculator who thinks the price will skyrocket and uses the futures contract as a speculation.
Futures contracts do not have the same type of inherent leverage as the stock option example above, but are often traded as part of highly leveraged transactions on commodity and futures exchanges. The margin requirement on a stock is 50%. This means that if you buy $ 50,000 of stock using margin, you must use $ 25,000 of your own money. The requirement for futures contracts can be as low as 3%. This means that you only need $ 1,500 for the same $ 50,000 transaction. But remember, that means if the price of the underlying asset drops by just 3%, you will be wiped out.
Stock options are in the form of call or put options. A call is a bet that the stock price will go up, and a put is a bet that the price will go down. The stock option gives you the right, but not the obligation, to buy or sell the stock at the strike price when the option expires.
As we mentioned above, you can use stock options to hedge your most important positions or use them as a leveraged way to trade a stock. We do not recommend that you get into options trading, but we recommend that you make smart use of stock options to generate income with covered calls or naked puts.
Stock options differ from futures contracts in that they give the contract holder the right to buy or sell the stock, but there is no obligation.
Futures contracts are futures contracts that do not trade on an open exchange. Each futures contract is a personalized contract between the two parties.
Due to their nature of over-the-counter (OTC) contracts, futures contracts carry counterparty risks that futures contracts would not have. You must guarantee the capacity of the counterparty to the contract to fulfill its obligations.
Swaps are another over-the-counter derivative typically used to hedge interest rates. With this instrument, you trade the cash flow with a counterparty. For example, if you borrow $ 50,000 at a variable rate, you could hedge the interest rates by using a third party swap.
The third party would make the payments on the debt, and you would pay them instead. The interest rate you pay the third party would be higher than the original rate on the debt. If interest rates go up you will win, but if they don’t, the third party makes a profit.
Advantages and disadvantages of derivatives
Let’s sum up what we talked about with a list of pros and cons for derivatives:
- Risk coverage / mitigation: Use derivatives to hedge the price of an asset or equity investment to which you are overly exposed.
- Blocked price: Set your price now so you can plan accordingly.
- Leverage: Control far more assets than the actual amount of money you have.
- Returned: Sell derivatives to traders looking for leverage to produce stable income.
- Volume issues: Not all of the underlying assets have popular derivatives. I cannot count the number of times I have tried to sell covered calls only to find that only three or four contracts trade each day. When this happens, the derivative can be very difficult to value and you will likely have a huge supply / demand spread.
- Time limit: Derivatives inherently expire on a certain date. If you buy a call option and the price of the underlying stock hits the moon one day after the option expires, you’re out of luck.
- Counterparty risk: Any over-the-counter derivative carries the risk that your counterparty will rip you off or simply not be able to fulfill their half of the contract.
- Leverage: This aspect is both for and against. If the underlying asset has grown dramatically, you’re in gold (maybe literally). If he has a huge downward movement, you’re done.
History of derivatives
We will end this derivative odyssey with a brief history. Unsurprisingly, it started with commodities and farmers. What good story does not have?
As early as 8000 BC, the ancient Sumerians used clay tokens to enter into a futures / futures contract to deliver goods at a future date. This type of contract lasted at least until the days of the Code of Hammurabi in Mesopotamia.
In 500 BC Greece, the first options (remember, an option is like a future, but there is no obligation) were traded. There are historical anecdotes about options and futures around the world from medieval times and into the 1800s when the Chicago Board of Trade was formed and derivatives began to modernize.
The Chicago Board of Trade is now called the Chicago Mercantile Exchange, with more than 19 million contracts traded daily last year. Clay tokens have turned into highly leveraged futures contracts, but there are still farmers looking to lower their risk and speculators wanting to.