How To Trade Derivatives

Derivatives are very advanced tools available to traders. It is important for every investor to be aware of them and to know how they work so that he or she can make an informed decision as to whether or not they want to include them in their portfolio. A derivative is a type of investment whose price is determined by a variety of different factors, depending on what type of derivative contract you are trading. However, the contract derives its value from an underlying asset. This underlying asset is often another form of security, such as shares in a company, or a certain amount of gold. The underlying asset can even be another derivative, or in some cases it isn’t even an asset. In these cases the contracts are equivalent to gambling. For instance there are futures contracts that are based on the weather (a future is a type of derivative). This article will primarily focus on the two main types of derivatives: options and futures. There are, however many other types of derivative investments in the world.

It is important to note that derivative’s trading is not for the risk averse, in fact this is one of the most high-risk high-reward investments there is. As a result they are not typically used to make money (what is termed speculation) but rather to hedge or manage risk. This leads to a contradiction, how can one of the riskiest investments be used to minimize risk? Keep reading to find out.

Let’s start with options. Options contracts provide the owner with the option, but not the obligation, to purchase or sell an underlying asset at a specific price before a certain date. There are two types of options, calls and puts. A call gives the owner the option to buy an asset. A put gives the owner the option to sell an asset. Let’s go over two possible examples to illustrate how options work. Let’s say that you wanted to buy a large piece of land beside a lake to build your retirement house on, but you won’t have the money to buy the land for a year. So you enter into an option’s contract with the owner. The contract gives you the option to buy the land in one year for $2 million. You pay $50,000 for the option. Now one of two situations arises. One year from now, it is found that the land has a large deposit of gold under it and it is now worth a lot more than $2 million. Because the owner sold you the option, you can still buy it for $2 million. This means that you make a net profit on the property because you paid $2 million (plus fifty thousand dollars) for the property that is worth a lot more. Alternatively, let’s say that in one year it is found that the land is contaminated with heavy metals and is uninhabitable. You would simply not exercise the option. You would loose the fifty thousand you paid for the option, but you would not have to buy the house (which is now worth a lot less than $2 million, the amount you would have to pay for it). This illustrates how options can be used to speculate on the price movement of an asset. Options can also be used as part of a hedging strategy. To illustrate this role, let’s use a put. Let’s say that an investor (we’ll call him mark) purchases 100 shares in a company at $20 a share. Mark is willing to loose $3 a share and decides to ensure that is the most he can loose. He purchases a put option to sell 100 shares at 17$ a share. If the price drops below $17, he can still sell his share at $17. If the price doesn’t fall below $17, he can let his option expire. Thus he is protected because he cannot loose more than $3 a share.

Next are futures. A future’s contract is a contract between a buyer and a seller of a commodity to purchase a certain amount of the commodity on a certain date at a certain price. The necessity for this system originated with farmers. Take a wheat farmer for instance. Before the establishment of the futures market, the farmer would have had no way of gauging demand for his wheat. He would either have produced more wheat than he can sell, or less wheat than is needed. Either way, he doesn’t make as much money as he could have. The futures market allow him to enter a contract to sell a certain amount of wheat at an agreed upon price. This allows him to produce the exact amount of wheat that he needs, no excess, no shortage. Nowadays, most futures contracts don’t actually result in the delivery of the physical goods. This means that any investor can use them without having to worry about what to actually do with the wheat once it arrives. Where Futures derive their value is from the agreed upon price. This price is set in stone, no matter what happens to the price of that commodity on the market between the date the contract is signed and the date of delivery. This means that if a contract specifies that 50 barrels of crude oil will be bought and sold in one month’s time for $100 a barrel, and if in one month, the price of crude oil is $90 a barrel, than the buyer will loose $10 a barrel and the seller will gain $10 a barrel. In the futures market, the gains and losses from a contract are added and deducted from the accounts of the buyer and seller on a daily basis, while the position is still open. This differs from the stock market and option’s market where profits and losses are only realized once the position is closed. Using futures for speculation entails a great deal of risk. This is because you are betting on whether or not the price of a commodity will be higher or lower (depending on whether you are the buyer or seller) on the delivery date. Futures can be used to great effect as part of a hedging strategy. For example, if an American investor wanted to invest in a Japanese company traded on a Japanese exchange, he or she would assume a lot of risk. There would be the risk assumed on the original investment as well as a currency risk, because the relative value of the American dollar and the yen shifts over time. To minimize the currency risk, the investor may enter a currency future’s contract, allowing him or her to convert his or her yen back to American dollars at a predetermined exchange rate.

This is just a basic introduction to derivatives. As I hope you have seen, they are very complicated, and there are many ways they can be used. I hope this article has helped.

By: Neil Litwin

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For more information on trading, investments, and the financial markets, please visit my site. I started being interested in the financial markets when I was very young. After having made a lot of money, I have decided to start a blog to share my knowledge.