Derivatives: Everything You Need to Know
If you’re interested in trading, you’ve probably heard the term “derivatives” before. But what are derivatives, exactly? In this blog post, we’ll give you a breakdown of what derivatives are, the different types of derivatives, and how they work.
What are derivatives?
Derivatives are financial instruments that derive their value from an underlying asset. The underlying asset can be anything from commodities, stocks, bonds, or even other derivatives. The value of a derivative is based on the price movements of the underlying asset.
Derivatives are traded on exchanges and can be used for speculation, hedging, or arbitrage purposes. They are made up of contracts between two parties, and the contract specifies the price of the derivative, the underlying asset, and the date of the contract’s expiration.
The Different Types of Derivatives
There are four main types of derivatives: futures, options, swaps, and forwards.
Futures
Futures are contracts that obligate the buyer to purchase an underlying asset at a specific price and date. Futures are traded on an exchange and standardized to include the quantity, price, and delivery date of the asset.
Futures are commonly used for commodities trading, such as oil or gold. An oil company might buy a futures contract to lock in the price they want to pay for oil in the future.
Options
Options are contracts that give the buyer the right but not the obligation to buy or sell an underlying asset at a specific price and date. There are two types of options: call options and put options.
A call option gives the buyer the right to buy an underlying asset at a specific price and date. A put option gives the buyer the right to sell an underlying asset at a specific price and date.
Options are commonly used for stock trading. An investor might buy a call option if they believe the stock price will go up or a put option if they believe the stock price will go down.
Swaps
Swaps are contracts between two parties to exchange one cash flow for another. The most common swap is an interest rate swap, where one party pays a fixed interest rate and the other party pays a floating interest rate.
Swaps are commonly used for hedging purposes or to take advantage of differences in interest rates.
Forwards
Forwards are similar to futures, but they are not traded on an exchange and are not standardized. The price, quantity, and date of delivery of the underlying asset are specified in the contract.
Forwards are commonly used for currency trading. A company might enter into a forward contract to protect against fluctuations in currency exchange rates.
How Do Derivatives Work?
Derivatives work by leveraging the price movements of the underlying asset. For example, let’s say an investor buys a call option for a stock with a strike price of $50. If the stock price goes up to $60, the investor can exercise the option and buy the stock at the lower price of $50, then immediately sell it for $60, making a profit of $10.
Derivatives can also be used for hedging purposes. For example, an airline might buy a futures contract for oil to lock in a price for their fuel. If the price of oil goes up, the airline is protected from the price increase.
The Risks of Derivatives
While derivatives can be useful financial instruments, they also come with risks. One risk is the possibility of losing all of the money invested in the derivative.
Another risk is counterparty risk, which is the risk that the other party in the derivative contract will not be able to fulfill their obligations.
Finally, derivatives can also be used for speculative purposes, which can lead to volatile price swings and market instability.
Conclusion
Derivatives are complex financial instruments that can be useful for hedging, arbitrage, or speculation purposes. There are four main types of derivatives: futures, options, swaps, and forwards. Derivatives work by leveraging the price movements of the underlying asset, but they also come with risks. It’s important to fully understand the risks and potential benefits of derivatives before investing in them.