Derivatives 101


on October 22, 2020
Investing has grown more complicated in recent decades, with the creation of numerous derivative instruments offering new ways to manage money. The use of derivatives to hedge risk and improve returns has been around for generations, particularly in the farming industry, where one party to a contract agrees to sell goods or livestock to a counter-party who agrees to buy those goods or livestock at a specific price on a specific date. This contractual approach was revolutionary when first introduced, replacing the simple handshake.
The simplest derivative investment allows individuals to buy or sell an option on a security. The investor does not own the underlying asset but they make a bet on the direction of price movement via an agreement with counter-party or exchange. There are many types of derivative instruments, including options, swaps, futures, and forward contracts. Derivatives have numerous uses while incurring various levels of risks but are generally considered a sound way to participate in the financial markets.
A Quick Review of Terms
Derivatives are difficult for the general public to understand partly because they have a unique language. For instance, many instruments have counterparties who take the other side of the trade. Each derivative has an underlying asset that dictates its pricing, risk, and basic term structure. The perceived risk of the underlying asset influences the perceived risk of the derivative.
The pricing of the derivative may feature a strike price. This is the price at which it may be exercised. There may also be a call price with fixed income derivatives, which signifies the price at which an issuer can convert a security. Many derivatives force the investor to take a bullish stance with a long position, a bearish stance with a short position, or a neutral stance with a hedged position that can include long and short features.
How Derivatives Can Fit into a Portfolio
Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement. Hedging a position is usually done to protect against or to insure the risk of an asset. For example, the owner of a stock buys a put option if they want to protect the portfolio against a decline. This shareholder makes money if the stock rises but also loses less money if the stock falls because the put option pays off. 
Derivatives can greatly increase leverage. Leveraging through options works especially well in volatile markets. When the price of the underlying asset moves significantly and in a favorable direction, options magnify this movement. Many investors watch the Chicago Board Options Exchange Volatility Index (VIX) to measure potential leverage because it also predicts the volatility of S&P 500 Index options. For obvious reasons, high volatility can increase the value and cost of both puts and calls.
Derivatives can greatly increase leverage—when the price of the underlying asset moves significantly and in a favorable direction, options magnify this movement.
Investors also use derivatives to bet on the future price of the asset through speculation. Large speculative plays can be executed cheaply because options offer investors the ability to leverage their positions at a fraction of the cost of an underlying asset.  
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Derivatives 101
Trading Derivatives
Derivatives can be bought or sold in two ways—​over-the-counter (OTC) or on an exchange. OTC derivatives are contracts that are made privately between parties, such as swap agreements, in an unregulated venue. On the other hand, derivatives that trade on an exchange are standardized contracts. There is counterparty risk when trading over the counter because contracts are unregulated, while exchange derivatives are not subject to this risk due to clearing houses acting as intermediaries.
Types of Derivatives
There are three basic types of contracts. These include options, swaps, and futures/forward contracts—all three have many variations. Options are contracts that give the right but not the obligation to buy or sell an asset. Investors typically use option contracts when they don't want to take a position in the underlying asset but still want to increase exposure in case of large price movement.
There are dozens of options strategies but the most common include:
Swaps are derivatives where counterparties exchange cash flows or other variables associated with different investments. A swap occurs many times because one party has a comparative advantage, like borrowing funds under variable interest rates, while another party can borrow more freely at fixed rates. The simplest variation of a swap is called plain vanilla—the most simple form of an asset or financial instrument—but there are many types, including:
Parties in forward and future contracts agree to buy or sell an asset in the future for a specified price. These contracts are usually written using the spot or the most current price. The purchaser's profit or loss is calculated by the difference between the spot price at the time of delivery and the forward or future price. These contracts are typically used to hedge risk or to speculate. Futures are standardized contracts that trade on exchanges while forwards are non-standard, trading over the counter.
The Bottom Line
Investors looking to protect or assume risk in a portfolio can employ long, short, or neutral derivative strategies that seek to hedge, speculate, or increase leverage. The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a broader portfolio strategy.
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Forward Contracts vs. Futures Contracts: What's the Difference?
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Related Terms
What Is a Derivative?
A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. more
What Is a Volatility Swap?
A volatility swap is a forward contract with a payoff based on the realized volatility versus the implied volatility of the underlying asset. more
How a Put Works
A put option gives the holder the right to sell a certain amount of an underlying at a set price before the contract expires, but does not oblige him or her to do so. more
Zero-Coupon Inflation Swap (ZCIS) Definition
A zero-coupon inflation swap is a derivative where a fixed-rate payment on a notional amount is exchanged for a payment at the rate of inflation. more
Reference Equity Definition
Reference equity is the underlying asset that an investor is seeking price movement protection for in a derivatives transaction. more
Variance Swap
A variance swap allows counterparties to hedge or speculate directly on the volatility of an underlying asset. more
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