What is a Derivative? Understanding Financial Derivatives

When you think of investing, your mind might first jump to common types of assets like stocks and bonds. However, there are many other types of investable assets, including more complex ones like derivatives, which can help with areas such as risk management, while also sometimes adding risk to portfolios. 

As such, derivatives — which are technically contracts that provide exposure to other underlying assets — tend to be reserved for more advanced investors, including businesses that are trying to hedge their exposures. That said, some derivatives like options are increasingly making their way into the mainstream for individual investors. It's important to understand what derivatives are, how they work, and the risks before getting involved.

Definition of a derivative

A derivative is a contract that has a value that's derived from an underlying asset or index — hence the name "derivative." For example, options are derivatives because their value changes in relation to the price movement of the underlying stock. 

Key components of derivatives

The exact components of derivatives vary based on the type of derivative, but typically some common components include:

• Contract expiration date, such as when the right to buy or sell underlying securities terminates
• Contract size, such as how one options contract typically essentially gives you control over 100 underlying shares
• Pricing/margin, such as the cost to buy the derivative and/or the amount of margin that the buyer and seller need to put up to reduce the risk of a default. Some derivatives involve ongoing premiums, such as how with some swaps buyers pay premiums to sellers as a price for essentially reducing risk.
• Parties involved: Derivative contracts are arrangements between two entities, often referred to as counterparties. You may not need to sign physical documents like with typical contracts, but there's still an implicit or explicit agreement between the counterparties. Some derivatives trade on exchanges and the operational aspects of the trade are largely handled by intermediaries known as clearinghouses, meaning buyers and sellers generally don't directly interact. Others are traded over-the-counter (OTC), such as when two financial institutions negotiate a derivative contract directly with each other.

Types of derivatives

There are many types of derivatives, some of which trade OTC (e.g., directly between two banks), while some trade on public exchanges, like the Chicago Mercantile Exchange (part of CME Group).

Some common types of derivatives include:

Futures 

This is an arrangement where an investor can purchase or sell a set amount of a specific asset — such as commodities — at a set price at a future date. For example, a farmer might sell a futures contract to ensure that they can sell their agricultural products at a particular price in the future, regardless of what happens with the market between now and then. That could mean they end up selling for less than what the market value ultimately ends up being, but it can reduce the risk of facing a low price. Meanwhile, futures contracts, like other derivatives, can be traded prior to expiration, with the price varying based on the likelihood of the futures price being favorable or not.

Options

This type of derivative allows the investor to buy or sell a security at a set price by a specific date. If you purchase a "call option," you get the right to purchase shares at a later date at a specific price. A "put option" offers you the ability to sell shares at a later date at a specific price. 

Swaps

With swaps, the two parties involved agree to swap payments or liabilities with each other, based on underlying issues like commodity prices or interest rates. For example, a credit default swap involves transferring the risk of default — the buyer pays premiums to the seller in exchange for the seller compensating the buyer in the event the issuer defaults. The seller hopes that they can collect enough premiums to offset the times they do end up having to pay for a default, while the buyer reduces their overall risk, despite losing some return due to the premiums.

Forwards

Forward contracts are very similar to futures contracts in that they are arrangements to buy or sell assets at a set price at a set time in the future. However, it's important to note that forward contracts are not traded on an exchange. 

How do derivatives work?

Derivatives work as contracts that get their value based on underlying conditions, such as stock prices or interest rates. These financial instruments can be traded, but they don't provide direct ownership of the underlying assets. However, you may be able to use a derivative to gain the right to buy or sell underlying assets. 

Examples of derivative transactions

Derivatives can be pretty complex, so it helps to look at specific examples. 

With options, for instance, suppose you purchase the right to buy 100 shares of ABC Company for $100 per share in one month. And perhaps the contract cost $100. 

Currently, the stock might be trading at $95. So, you're essentially betting that the stock price will move above $100 (and often more, when factoring in the premium paid for the options contract) within a month.

If the stock starts trading at $110, you might exercise the contract and buy 100 shares at $100, which you could then sell right away for $110. Thus, you'd gain $1,000 from the difference between the option price and the current market price, though after deducting the $100 you paid in premium you'd be at a $900 gain, minus any fees and taxes.

In practicality, however, executing the option is rare. Rather than going through the process of putting up $10,000 to buy 100 shares at $100, and then going through the selling process, you could simply sell the options contract prior to expiration. Generally, the price of the derivatives contract reflects the underlying movement in the stock price, so you could expect to gain a similar amount by selling the contract as if you exercised the option. However, if the stock never reaches $100, the option would expire as worthless and you'd lose all of the premium if you held until the expiration.

Another example could be buying oil futures. Maybe crude oil is trading at $75 per barrel, but you buy a futures contract based on the price being $70 next year. For the seller, they're potentially de-risking, as they know they can sell the oil for a minimum of $70, so there's not a ton of downside risk from the current price. For you as the buyer, though, if oil ends up being $100 per barrel, then being able to buy at $70 is probably a great deal (you'll have to factor in the premiums and risk, though).

Like with options, actually exercising the futures contract is rare — especially because the average person isn't going to take possession of the 1,000 barrels of oil that a standard futures contract represents. Instead, you could sell the futures contract prior to expiration for a similar gain. Perhaps an energy company would buy that contract from you so that they could take possession of the oil at that price. In many cases, though, the issue is resolved by exchanging money that represents the pricing differences, rather than taking physical possession of the underlying asset.

On the other hand, if oil falls below $70, your contract is worthless because there's no point in buying at $70 when the current price is lower.

Real-world applications of derivatives

Derivatives aren't just esoteric financial instruments. They serve real-world purposes, such as enabling companies to de-risk by locking in energy prices with futures. Agricultural producers often use futures to ensure a minimum price for their crops, rather than taking the risk that price ends up not being high enough to cover their operating costs.

Swaps also have real-world applications like enabling two real estate developers to exchange interest rates without having to refinance. 

For example, one might hold a fixed-interest-rate loan but wants to try to take advantage of potentially falling interest rates; so they could enter into a swap agreement with another developer that has an adjustable-rate loan but wants to gain more certainty over their interest expenses. Thus, the swap enables the two developers to pay interest to one another based on what's happening with interest rates, and they both get what they want from a risk perspective, without having to get banks involved in issuing new loans.

Common uses of derivatives in finance

In finance, derivatives can serve many purposes, but typically there's a lean toward either managing risk or seeking additional returns. Specifically, derivatives are often used for:

Hedging risk

According to the San José State University Department of Economics, derivatives play an important economic role from a risk transfer perspective. With swaps, for instance, the risk is transferred to other parties who are willing to take it on for a fee. In this way, derivatives are similar to the insurance industry, but instead of hedging against the risk of facing high home repairs with homeowners insurance, you might use derivatives to hedge against risks such as the price of a stock dropping. 

You can hedge against risk with derivative contracts by purchasing a contract that has a value that will help offset other losses you may have in other positions. For example, if you bought a stock at $100 per share, and you're worried about it falling well below that mark, you might buy a put option priced at $90. If the stock falls below that mark prior to expiration, you're gaining value with the put option to offset some of the losses from the stock that you bought at $100. However, you're also giving up some potential gains, as the price of the option cuts into your potential returns.

Note: Although derivatives are designed to transfer risk, they don't always act as intended. As the San José State University Department of Economics pointed out, a contributor to the 2008 financial crisis was that businesses thought they were transferring risk via mortgage-backed securities (a type of derivative based on underlying mortgages), but they ended up taking on counterparty risk because the other party wasn't always prepared to handle as many defaults as ended up happening.

Speculation

Speculation is a strategy where investors buy a type of asset like derivatives and bet that the price will shift in their favor in the future. The investor using this strategy hopes to maximize profits, but as the term suggests, it's all speculative and can be very risky. 

"Derivatives are unlike [many other] securities in that they are [often] more of a bet than an investment. Most common derivative contracts have an expiration date, which means a limited time for them to achieve a profit," explains Asher Rogovy, chief investment officer at Magnifina, a Registered Investment Advisor. 

Other securities like stock and bonds, "on the other hand, are either perpetual or repayable, so investors can simply hold them for the long term. The key benefit of derivatives over [many other] securities is leverage. If a trader has conviction about a price move within a certain timeframe, they can gain a much higher profit by trading derivatives instead of the underlying security. Of course, with this higher profit potential, comes higher risk."

Derivatives often provide leverage by enabling you to gain exposure to a large underlying value of assets for a relatively small price. For example, rather than spending $10,000 to buy 100 shares of a stock, you might spend a few hundred dollars on an options contract that gives you exposure to 100 shares. The price of the contract often moves as if you owned 100 shares, not just one. However, this leverage comes at a cost, as reflected in the premium. Many options expire worthless, so the money that you spent to gain this leverage could have potentially been wasted.

Quick tip: Before getting started investing in derivatives, you want to assess the overall counterparty risk which refers to the likelihood that the other party won't hold up their end of the bargain. If buying through an exchange, counterparty risk is often limited, but you should still understand what you're agreeing to and with whom.

Arbitrage

Occasionally, derivatives provide arbitrage opportunities, meaning that you can take advantage of pricing differences between different markets to essentially lock in risk-free profit. For example, it's possible that a put option and a call option for certain ETFs are priced in ways that no matter which way the index moves, you're guaranteed to net a positive return.

However, this is hard to find, and arbitrage opportunities can disappear quickly as markets adjust to changing conditions. As such, arbitrage is typically left to professional investors with the tools and expertise to find these opportunities, especially because if you inaccurately trade based on what you think is an arbitrage opportunity (but it's not really), you could lose a lot of money.

Risks and benefits of derivatives

Derivatives can increase or decrease risk, depending on how they're used. They can also increase potential gains and losses.

Risk management through hedging

By using derivatives to hedge current positions, you can reduce overall risk. For example, credit default swaps can hedge against the risk of a bond default (although these are usually used by institutional investors, not retail investors). Or, if you have certain stock positions that you want to hedge against, without having to sell your stock, you could buy puts to limit the potential downside. 

Speculative risks involved

Derivatives can also increase risk, while providing the potential for increased rewards, especially when used for speculative purposes. For example, buying call options can give you the potential to enjoy significant gains in stock prices, without having to put in much cash upfront. However, if the option expires worthless, you lose the entire investment, as opposed to buying stocks directly where you can hold the asset indefinitely and hope the price recovers.

"Derivatives aren't for beginner or casual investors. Because they are essentially bets, Wall Street does a very good job of making sure they are accurately priced," notes Rogovy. "Because derivatives tend to expire, there's less margin for error. With securities, some bad trades may be salvaged by holding for the long term. Inexperienced traders are notorious for losing significant amounts of capital on risky stock option bets."

Quick tip: Before engaging in any trading, understand how derivatives work with your overall financial goals and how you intend to use them to manage risk and seek returns.

FAQs about derivatives