If you’re seeking investment opportunities outside of the conventional stock, ETF, and bond markets, the realm of derivatives can be a good fit. Derivatives play an important role in facilitating both hedging and speculation, which are more difficult to achieve with more traditional methods.
But “What is a derivatives contract?” is a reasonable question to ask a newcomer to the market. Is that so? If so, let’s examine their definition, operation, usage, types, and more.
How does a derivative contract work?
The Office of the Comptroller of the Currency, a division of the United States Department of the Treasury, defines a derivative as a financial contract whose value derives from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity, credit, and equity prices.
There are several factors that affect pricing, the most important of which are financial and economic factors. Factors unrelated to money, like the weather, influence the prices of some commodities. This is especially true for commodities related to food production.
The word “derivative” derives from this concept because the contract’s value depends on the underlying asset. Investing in a derivative contract is risky because its value fluctuates with the asset values.
Investing in derivatives, like any other kind of investment, is not without its risks. With their assistance, we can lock in rates ahead of time, speculate, or mitigate risk. In some cases, they can improve overall diversification, and they are frequently very leverageable.
Concerning the negatives, determining the contract’s worth can be difficult. Risky over-the-counter (OTC) variations may also be vulnerable to counterparty default. Lastly, these arrangements can be quite difficult to understand, and the powerful forces of supply and demand make them more difficult for rookie investors to navigate.
Understanding Derivative Contracts
If you want to know how a derivative works, it’s basically a contract where two or more people bet against each other on the value of an underlying asset. As one side’s position gains traction, it becomes more expensive to buy a derivatives contract with that side than the other.
You can trade derivatives on exchanges or over-the-counter, the latter of which is more discreet. Derivatives are often used as a hedging tool, protecting investors from potential losses in other areas of their portfolio.
Another option is to use derivatives for speculation. Investors may look for comparable derivatives contracts that could help them make money in the future if they think the value of an underlying contract might change in the next several months. Here, the key is to identify a third party that thinks the inverse is possible. Moreover, in the end, only one will do well.
Applications of Derivative Contracts in Real-World Environments
An easy way for a European investor to use the derivatives market to hedge their bets is for them to purchase American equities on an American stock exchange. Currencies pose a risk for this investor. The value of his native country’s currency could go up or down, affecting his U.S. stock winnings or perhaps wiping them out completely. A currency futures contract is one type of derivative financial instrument that an investor might use to hedge against this risk.
A distinct set of factors drive speculation. To potentially profit from future asset gains, an investor who thinks a stock is cheap could look into futures contracts. Using a contract, an investor can lock in a future purchase price for an asset at today’s price. Assuming they spend less on the asset than it is worth, they stand to earn if its price goes up. The opposing side will benefit, though, because they must go through with the purchase even if they are mistaken.
Different kinds of derivative contracts
Either on an exchange or in an OTC setting, you can find a wide variety of derivatives contracts. Lock and choice are the two main ways to classify them.
All types of locks include futures, forwards, and swaps. If this is the case, the parties involved remain obligated to buy, sell, or swap the asset at the original agreed-upon price, regardless of the asset’s value fluctuations throughout the contract term.
One benefit of options, especially stock options, is that they do not obligate the holder to actually purchase or sell the underlying asset. Consequently, up until the contract’s expiration date, they are free to think about how the asset’s price changes before making a decision. Alternatives with contractual obligations to proceed, due to their lack of risk, are versatile enough for hedging and speculation.
Are contracts for the future considered derivatives?
Futures contracts (or “futures” for short) are considered derivatives because their value is based on the performance of an underlying asset over the contract period. Many markets, including the Chicago Mercantile Exchange, trade this derivative product. Since futures are subject to regulation, this adds an additional safeguard when compared to OTC derivatives, which are not.
For the most part, speculating is the main use case for futures contracts. Investors are more inclined to investigate them if they anticipate a substantial change in the value of an item in the near future.
Futures contracts are likewise derivatives. Unlike futures, they undergo less regulation due to their over-the-counter trading. This not only makes them more adaptable to individual needs, but it also allows them to reflect assets that aren’t accessible through futures. Though their use extends beyond hedging, they carry a much higher degree of risk than futures.
Is investing in derivatives a smart move?
Your financial objectives, risk appetite, degree of comfort, and availability to appropriate exchanges or OTC marketplaces will determine whether derivatives are beneficial portfolio additions. The intricacy of these contracts generally means they aren’t a good choice for newcomers, especially those with smaller portfolios that don’t need hedging as much.
Nevertheless, they can supplement your investing plan with additional diversification if you are familiar with their operation and comfortable with the associated risks. Keeping them as an option and implying they mesh nicely with your overarching goal is, thus, not a bad idea.
