What Are Derivatives and How Do they Work?

In the context of financial markets, "derivatives" refer to financial contracts whose value is derived from an underlying asset, index, or a set of assets. Unlike equities or bonds, derivatives are not assets themselves but are financial instruments based on the value of other financial assets like stocks, bonds, commodities, currencies, interest rates, or market indices.

Derivatives are often used by investors and traders for the purposes of hedging, but may also be used for speculation and/or arbitrage. Some of the most common forms of derivatives include options, futures and swaps.

The value of a derivative is intrinsically linked to the value of an underlying asset or set of assets like stocks, bonds, commodities, currencies, interest rates, or market indices. 

As such, the relationship between the value of a derivative and its underlying asset can be complex and is often determined by a variety of factors including, but not limited to, the price of the underlying asset, time decay, volatility, and interest rates.

The following provides an overview of the mechanics for options, futures and swaps.

Options

• Mechanics: Provides the option holder with the right, but not the obligation, to buy (call) or sell (put) an asset at a predetermined price (strike price) by or on a specific date
• Markets: Can be traded on exchanges or over-the-counter (OTC)
• Strategic Purpose: Used for hedging and speculative activities. For example, a stock investor might purchase a put option to protect against a potential price drop

Futures Contracts

• Mechanics: These contracts oblige the buyer to purchase, and the seller to sell, a specific asset at a predetermined future date and price
• Markets: Traded on standardized exchanges
• Strategic Purpose: Commonly used for hedging. For instance, a corn farmer might use corn futures to lock in a selling price for his harvest, reducing the uncertainty of a volatile market

Swaps

• Mechanics: Two parties exchange one stream of cash flows for another. For instance, in an interest rate swap, one party might swap fixed-rate payments for variable-rate payments from another party
• Markets: Typically traded OTC
  Strategic Purpose: Used to manage or hedge interest rate or currency risk, among other things

Derivatives serve various purposes in financial markets and can be employed by different types of participants, including individual investors, financial institutions, and corporations. Here are some of the primary purposes:

• Risk management

• Speculation

• Arbitrage

• Portfolio Management

• Income Generation

While derivatives can be useful for various strategic objectives, they come with their own set of risks and complexities. 

As such, they are generally best-suited for sophisticated investors and businesses who understand these risks and have the means to manage them.

For these reasons, always trade responsibly, and consider consulting with a professional before engaging in derivatives trading.

Derivatives offer a range of benefits but also come with significant risks. Some of the high-level pros and cons are outlined below:

Pros

• Risk Management (Hedging): Derivatives can be an effective way to manage various types of risk, including price, interest rate, and currency risk. Businesses and investors can use them to lock in costs or revenues, protecting against adverse market movements
• Leverage: Because derivatives often require a small upfront investment (known as the margin) to control a large asset, they offer significant leverage. This means that a small price movement in the underlying asset can result in large profits. However, the flip side is also true, and such leverage can produce large losses, as well 
• Speculation and High Returns: For those looking to speculate on asset prices, derivatives offer the potential for high returns, again due to the leverage involved
• Price Discovery: Futures markets, in particular, play a crucial role in price discovery, helping to reveal information about future prices of assets
• Market Efficiency: By allowing for hedging and speculation, derivatives can contribute to more liquid and efficient markets
• Capital Efficiency: Derivatives can sometimes be a more capital-efficient way to gain exposure to an asset without buying the underlying asset itself 
• Diversification: Derivatives can help investors create more diversified portfolios. For example, investors can use derivatives to construct 'synthetic' positions in assets or markets that might otherwise be difficult to access
• Flexibility: Especially in the case of OTC derivatives, contracts can be customized to suit the specific needs and risk profile of the parties involved
• Income Generation: Through strategies like covered call writing, derivatives can be used to generate additional income in an investment portfolio

Cons

• Complexity: Derivatives can be extremely complex and are often poorly understood, even by sophisticated investors. This complexity can lead to significant financial losses
• Leverage Risks: The same leverage that can lead to large profits can also result in large losses, possibly exceeding the initial investment
• Counterparty Risk: In OTC derivatives, there's a risk that the counterparty will default, potentially leading to significant losses
• Liquidity Risk: Some derivatives, especially complex or customized OTC products, may be difficult to unwind or trade, posing liquidity risks
• Market Risk: Just like any financial investment, derivatives are subject to market risks caused by unexpected changes in market variables like asset prices and interest rates
• Systemic Risk: Large-scale trading or a major default in derivatives can lead to systemic risks, affecting broader financial markets and institutions. This was evident during the 2008 financial crisis
• Costs and Fees: While the use of derivatives can be capital efficient in some instances, the use of derivatives may also involve commissions, bid-ask spreads, and other trading costs that can eat into profits
• Opportunity Costs: When used for hedging, the elimination of downside risk also means giving up potential gains if the market moves in a favorable direction

Some of the most common forms of derivatives include options, futures, swaps and forwards. Further details are outlined below.

Options Contracts

• Mechanics: Provides the option holder with the right, but not the obligation, to buy (call) or sell (put) an asset at a predetermined price (strike price) by or on a specific date
• Markets: Can be traded on exchanges or over-the-counter (OTC)
• Strategic Purpose: Used for hedging and speculative activities. For example, a stock investor might purchase a put option to protect against a potential price drop

Futures Contracts

• Mechanics: These contracts oblige the buyer to purchase, and the seller to sell, a specific asset at a predetermined future date and price
• Markets: Traded on standardized exchanges
• Strategic Purpose: Commonly used for hedging. For instance, a corn farmer might use corn futures to lock in a selling price for his harvest, reducing the uncertainty of a volatile market

Swaps

• Mechanics: Two parties exchange one stream of cash flows for another. For instance, in an interest rate swap, one party might swap fixed-rate payments for variable-rate payments from another party
• Markets: Typically traded OTC
• Strategic Purpose: Used to manage or hedge interest rate or currency risk, among other things

Forward Contracts

• Mechanics: Similar to futures, but they are private agreements between two parties and are not standardized
• Markets: Traded exclusively OTC
• Strategic Purpose: Often used for hedging. For example, an exporter may lock in the future value of a currency to mitigate currency risk

Outlined below is a brief example of each type of derivative.

Options

Example: An investor buys a call option for Apple stock with a strike price of $150, expiring in one month. If Apple's stock price rises above $150 within that month, the investor can exercise the option to buy shares at $150, potentially selling them for a profit at the current higher market price. In this instance, the investor might instead elect to sell the option for a profit, prior to expiration. 

Futures

Example: A farmer agrees to sell 1,000 bushels of wheat at $5 per bushel in a futures contract maturing in six months. When the contract expires, the farmer is obligated to deliver the wheat and the buyer is obligated to pay $5,000, regardless of the current market price.

Swaps

Example: Company A has a variable interest rate loan, while Company B has a fixed interest rate loan. They enter into an interest rate swap agreement. Company A pays Company B a fixed interest rate, and Company B pays Company A a variable interest rate. This way, each company effectively converts its loan type to the other's loan type. 

Forwards

Example: An American electronics retailer expects to pay €1 million for inventory from a European supplier in three months. To hedge against currency risk, the retailer enters into a forward contract to buy €1 million at a predetermined exchange rate in three months. Both parties are obligated to honor the details of this agreement, regardless of market fluctuations.

Derivatives are traded by a diverse group of market participants for various reasons, ranging from risk management to speculation. Listed below are some of the primary market participants.

• Individuals

• Derivatives Market Makers

• Investment firms

• Hedge Funds

• Mutual Funds

• Exchange-Traded Funds (ETFs)

• Commodities Firms

• Banks

• Any Company Hedging Financial Risk

Trading derivatives involves several steps and considerations, some of the high-level steps and considerations are listed below.

1) Education and Research

• Learn the Basics: Understand the fundamental concepts of derivatives like options, futures, swaps, and forwards, including how they work and the risks involved

• Research Strategies: Familiarize yourself with trading strategies like hedging, speculation, and arbitrage. Choose the one that aligns with your financial goals and risk tolerance

2) Choosing a Platform and Account

• Select a Broker: Choose a reputable broker that offers the types of derivatives you wish to trade. Make sure the broker is regulated and offers a trading platform you find user-friendly

• Open an Account: Complete the application process, which usually involves providing identification and financial documents, and possibly passing a suitability test for trading derivatives. Open an account on tastytrade today and start trading options, futures, and stocks on the best trading platform

3) Planning and Analysis

• Develop a Trading Plan: Outline your objectives, risk tolerance, and strategies. Determine the kinds of derivatives that suit your plan

• Analysis: Consider fundamental and technical analysis, and other strategic approaches , in order to identify trading opportunities. This should help you determine attractive entry and exit points

4) Execution

• Place Orders: Use the trading platform to place orders. Familiarize yourself with order types like market, limit, and stop orders

• Margin and Leverage: Be aware that trading on margin (borrowing money to trade) amplifies both potential gains and potential losses. Make sure to manage your leverage carefully

5) Risk Management

• Position Sizing: Don't put all your capital into a single trade; consider diversifying across different assets or asset classes

• Monitor the Position: Keep an eye on your open positions and be prepared to adjust them

• Position Management: Use orders like stop-loss or take-profit to automatically close your position when it reaches a certain loss or profit level

6) Portfolio Analysis

• Track Performance: Regularly review your trades to see what's working and what isn't

• Adjust Strategy: Refine your trading plan and strategies based on performance, or any changes in your outlook, strategic approach, or risk tolerance

Keep in mind that trading derivatives carries substantial risk and it's possible to lose more than your initial investment.  

As such, they are generally best-suited for sophisticated investors and businesses who understand these risks and have the means to manage them. 

For these reasons, always trade responsibly, and consider consulting with a professional before engaging in derivatives trading.