Learning everything you need to know about financial assets and investing takes time and research. Some topics are more complex or less well-known by the general public, but that doesn’t mean they’re not important. Today, we will take a look at financial derivatives, which are often thought to be a more “advanced” concept for those that are more experienced with the stock market and investing.

This article will give an overview of derivatives, including what they are, why they matter, and how they work. Hopefully, this information will help you purposefully incorporate derivatives into your investment plan. Let’s get started!

What Are Derivatives? 

We use the term “derivative” when talking about a financial contract whose value is dependent on either an individual asset, a group of assets, or a benchmark. A derivative as a contract can only happen between two or more parties that can both trade either OTC (over-the-counter) or on an exchange. 

It’s important to note here that these contracts can be used to sell/buy all kinds of assets that have their own specific risks. Along with that, their prices always fluctuate depending on what’s happening with the underlying asset. 

Investors typically use derivatives as a way to access particular markets, and they normally get traded to hedge against risk. Additionally, they’re a good option for mitigating risk or assuming risk while expecting to earn a reward, also known as speculation. Derivatives can affect risk and be beneficial to both risk-seeking investors and risk-averse ones.

What’s the Purpose of Derivatives? 

Derivatives can have many different purposes; it’s no wonder that they’re considered to be a complex type of financial security. More advanced traders use derivatives in order to gain access to specific markets or to be able to trade particular kinds of assets. With that said, the value of all derivatives is based on their underlying asset. In most scenarios, this value comes in the form of stocks, bonds, currency, market indexes, or interest rates. 

Some of the reasons a trader might want to use a derivative are to hedge a position, give leverage to holding, or speculate on how an underlying asset will fluctuate in the coming days, weeks, or months. These assets are usually traded over-the-counter or on exchanges and are often purchased through brokerages. 

It’s vital here to remember that most of the time, companies hedge not because they’re speculating on the price of a commodity but because they’re trying to manage risk. In these scenarios, each party has its profit or profit margin built into the price, and hedging protects the money from being eliminated by changes in the underlying asset’s market price. 

Typically, over-the-counter derivatives hold more counterparty risk, meaning that there’s a danger for one of the parties in the contract to default. These kinds of contract trades are typically unregulated, and to hedge the risk, an investor might look into purchasing a currency derivative that will lock a specific exchange rate. Derivatives that can hedge this kind of risk are currency swaps and currency futures. 

To summarize, derivatives have two primary purposes for traders: hedging and speculation. 

Common Types of Financial Derivatives 

So far, we’ve discussed what financial derivatives are and how they are used. Now let’s talk about the different types of financial derivatives and how they differ from one another. 

Futures 

By signing a futures contract, the two parties agree to buy and sell an asset at a particular price sometime in the future. Because futures contracts bind both parties to a price, they are often used as a way to minimize risk in case the price of the underlying asset falls or rises, which can lead to someone having to either sell an asset at a low price or to buy it with a significant markup.

Futures help avoid that by ensuring that both parties agree to an acceptable rate, that’s usually based on the information they currently have in hand. 

Furthermore, futures are standardized, exchange-traded investments, which means you can purchase them in the same way you buy stocks, even if you don’t need a particular asset at a specific price. Similarly to stocks, losses and gains are settled on a daily basis, so traders can use them to speculate on short-term price fluctuations and don’t have to wait for the full length of the contract to expire. As futures are traded on an exchange, the chances of one of the parties having to default on the contract are reduced. 

Forwards 

Forward contracts are similar to futures; however, they’re set up over the counter, which means they are just private contracts between two parties. Of course, this means that they’re not regulated in the same way, so there’s more risk associated with using them, as one of the parties can easily default. Because of that, forwards aren’t usually recommended to the everyday investor who lacks expert-level experience in the stock market.

Even though forwards tend to hold more risk, they also enable investors to make a lot more customization of the terms, settlement options, and prices, which can lead to an increase in profit when done correctly.

Options 

You can think of options as non-binding versions of forwards and futures. They’re basically an agreement between two parties to buy and sell an asset at a particular price at a set date. However, the party that’s buying the derivative has no legal obligation to use it. Because of that, options typically require buyers to pay a premium that’s at least some of the value of the agreement. 

Two of the main types of options are American and European options; the type is determined by the way they’re enacted. European options are non-binding versions of a future or a forward contract. Because of that, the buyer of the contract can enforce it on the day it expires or simply not use it at all. On the other hand, American options can be enacted at any time up until they expire. However, they’re also not binding and can be let go without getting used. 

Options can both be traded over-the-counter and on exchanges. 

Swaps 

Swaps are derivatives that enable both parties to sign a contract and exchange cash flow or liabilities to get profits or cut costs. Swaps are commonly used with currencies, commodities, interest rates, and credit defaults. They were notoriously used during the housing collapse of 2008 when they were overleveraged and caused a chain reaction of major defaults. 

How swaps play out depends on the asset that’s being exchanged, and because of that, they hold a higher risk. Along with that, swaps are only done over the counter and only to companies and financial institutions. 

Risks Associated with Derivatives 

Like any other investment instrument, derivatives also hold particular risks that you should be aware of. Let’s take a look at some of the most notable ones. 

Market Risk 

Market risk is a term used to describe the general risk you take with any investment. Investors typically make their decision based on information they have, technical analysis, and other outside factors that they feel might impact the market. There’s no way to completely mitigate market risk; you just have to do your best to learn as much as you can about a particular investment before putting your money on the line. 

Counterparty Risk 

This kind of risk arises if one of the parties involved in a derivatives trade defaults on the contract. This risk is much higher if you’re doing OTC deals, as they’re not as regulated as typical trading exchanges. You can manage counterparty risk by working with dealers who you’re sure are trustworthy and won’t go back on their promise. 

Liquidity Risk 

This risk is applied to investors who plan to close out a derivative before it matures. Overall, the term liquidity risk looks at whether a company can pay off its debts without generating huge losses. Investors usually compare short-term liabilities and the company’s liquid assets when measuring liquidity risk. Companies with low liquidity risk can turn their investments into cases and thus prevent losses. 

Investing in Derivatives

Derivatives are often risky investments that are not suitable for all investors. For average investors, the best option for investing in derivatives is leveraged exchange-traded funds (ETFs) that are professionally managed and contain a portfolio of derivatives. Investing a small amount of your money into an ETF (as an average investor) is a great way to diversify your portfolio while managing risk simultaneously. 

In Conclusion

Derivatives are often considered to be a more advanced investment instrument. If you want to use them strategically to diversify your portfolio, speculate, and/or hedge against risk, it’s a good idea to work with proven professionals.

Derivatives may be considered a riskier investment option, but they also often offer higher profit margins and might be suitable for those willing to take more risk. Along with that, for more risk-averse investors, they can be a terrific way to diversify your portfolio and hedge against market fluctuations.

Our experts at Alpha Wealth Funds will not only help you understand the right moves you need to make in order to diversify and strengthen your portfolio, but they will also help you choose the best way to invest in derivatives according to your financial goals and future plans. 

Please feel free to reach out to me on this or any of your investment needs or questions. I may not always have the answers at my fingertips, but I promise I will get them for you. Michael Torrence

Calendly link https://calendly.com/mt-awf/intro Work: 435.658.1934 Contact: 330.284.3211
Michael Torrence – Investment Advisor Representative: Michael was born and raised in Ohio and attended The Ohio State University. After College, he was commissioned as a 2ndLt in the United States Marine Corps. He attended his initial training in Quantico, Virginia, then graduated at the top of his Primary Aviator Class and was selected for the Strike (Jet) Platform.

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