What are derivatives?

A derivative is a contract between two parties based on the underlying price of the security. It derives the value from the security. The most commonly used derivatives are futures and options. They are used to protect against future price changes or to make profit from future price changes. 

Options

When you buy an option, you buy a contract. That contract consists of the underlying security, for example stocks. The contract allows you to buy or sell an security at a set price before a specific date. Options come in two types:

  • Calls (buying securities for x price)
  • Puts (selling securities for x price)

Call options give you the right (not the obligation!) to buy shares at the set price at the set date listed in the contract. For example:

  1. You buy a call option for stock X with a current value of $25 per share. This contract expires after six months.
  2. The current trading price is also $25. In this case, you expect the price of stock X to rise within six months.
  3. With the call option you are eligible to buy stock x for $25 regardless of the real time trading price before the contract ends (within the set period of the contract, in this case six months).
  4. Within six months, the price for stock x rose from $25 to $35. The option allows you to buy stock x for $25. Meaning you are buying an x amount of shares (listed in the contract) with a $10 discount. After that you can sell the shares right away at market prices and make a profit. 

In other words, you are placing a long position expecting the price to rise in the future. But with the advantage that you are not obligated to buy anything. You can also decide to do nothing at all (in case the price went down instead of up). In that case you only pay the premium that needs to be paid when buying the contract.

Put options work the same way only the other way around. Put options give you the right to sell securities at the set price at the set date listed in the contract. You are basically shorting the market based on future predictions. If you think the current stock market is overpriced, you can use put options to take advantage of future drops in price.

Options are always traded at a premium. There are no potential further losses beside the premium. It may seem obvious but options are very risky. You are trading based on predictions. Whether these predictions come true or not totally depends on your own judgement and research.

Futures

Another derivative is futures. Futures are also contracts based on a set price and time. They work in the same way as options. The key difference is that the holder of the future is obligated to buy or sell at or before the specific end date of the future. Meaning, the future holder has to buy or sell for the price set in the contract. Whereas holders of options are not obligated to sell. This makes a huge difference for potential risks. But from another perspective, this creates a lot of certainty.

For example, companies use futures and other derivatives to protect themselves against future price changes. If a company depends on a certain ingredient (KFC needs chicken meat), changes in price might be a big threat for the business. To ensure they can buy ingredients for x price for the next six months, operations can continue without having to worry about future pricing of ingredients. Although this can backfire when prices go the other way (become even cheaper). But as companies make a living out of this they do have good predictions on future prices. In the same way, multinational companies can also use futures to protect themselves from fluctuations in currencies. 

CFDs

CFD stands for contract for difference. With a CFD you are agreeing to exchange the difference in price between the opening and closing of the trade within the set time frame. Just like trading options and futures, you are not buying the underlying security but a contract. CFDs are leveraged products which means they can be very risky. Leverage is mostly used for day trading or other strategies. Leverage means that you can buy in a large position with relatively low capital.
 

Derivative type Obliged to sell before end of contract Provide some kind of leverage
Options No Yes
Futures Yes Yes
CFDs Yes Yes

Overall derivatives are risky investments and should only be used if you know exactly how these products work.

Key Concepts:

  • Derivatives are risky investments based on future predictions.
  • Best known derivatives are:
    • Options
    • Futures
    • CFDs
  • When buying derivatives, you are buying a contract and not the underlying security.
  • When you buy options you have the right, not the obligation, to buy or sell.
  • When using futures or CFDs, you are obliged to buy or sell before the end of the contract.
  • Derivatives are considered leveraged products.
  • Should be used with care, not recommended for beginning traders and investors.


Chapters: The Ultimate Investing Guide

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