Financial Derivatives: Example, Trading, Options, & Investing


What are financial derivatives?

Derivatives are financial instruments whose price is determined based on the value of another commodity. Such a raw material, ie. underlying asset, can in principle be any product, such as currency, interest rate, stock, index or commodity. Derivatives refer to options, warrants, futures, futures and currency and interest rate swaps.

The word derivative can be explained as “derived from something underlying”.

The underlying product of a derivative is often a share or a bond, but can also be other securities or products.

The value of a derivative can change much faster than on “ordinary” securities.

You should not consider investing in derivatives if you do not feel convinced that you have sufficient knowledge to be able to determine what risk-taking the investment entails and that you are confident in your market analysis.

Derivatives – examples

There is a wide range of derivative products to choose from. One of the most popular types is CFD (Contracts for Difference) contracts.

When you trade CFDs, you enter into a contract to exchange the value that a certain asset has when the position is opened with the value that the asset has when the position is closed.

As with other derivatives, you never become the owner of the asset when you trade CFDs, but instead speculate in the underlying value.

Other examples of derivatives are options and futures contracts.

Derivatives – advantages and disadvantages

Benefits of derivatives

Derivatives can be used for hedging, which is a way to reduce losses in other positions.

This is because derivative products are more flexible to trade compared to if you were to trade the underlying asset directly.

In traditional trading, you open a long position by buying an asset with the hope that it will increase in value.

When you trade derivatives, however, you can also speculate in markets that decrease in value by opening a short position.

Some derivative products are traded with a collateral as a stake, which means that you only need to reserve a small proportion of the value of a position to gain full exposure to the market.

Any gain on the position is calculated based on the total value of the position, which means that the return on a successful trade is increased.

However, it also means that any losses are magnified.

It is therefore important to evaluate the total value and the possible losses for each position.

Disadvantages of derivatives

Derivatives are sometimes criticized for diluting market volatility.

Speculators have been accused of greed for rising fuel and food prices and of causing drastic fluctuations in the markets.

Price movements driven by speculation can lead to speculative bubbles that push up the intrinsic value of access to an abnormally high level.

When speculative bubbles burst, it often has a devastating effect on markets, and even on world economies.

This was the case, for example, in 2008 when the American real estate bubble burst.

To invest in derivatives

Derivative instruments can be traded either directly between a buyer and a seller or on a stock exchange. When you invest in derivatives, you get no access but you enter into an agreement to buy / sell something in the future, you trade with the risk that something will happen, for example a stock market decline.

All types of derivatives sold to consumers must have a current fact sheet. The fact sheet must contain basic facts about the product.

You must have access to the fact sheet in good time before a possible purchase of the product.

Read the fact sheet carefully so you understand what you are investing in and the risks you are taking.

Derivatives trading

Investing in derivatives is mainly speculating with risks. Some people want to take a risk, some want to protect themselves from a risk.

You can compare with an insurance company, which takes risks, for example that your house burns down, and you as a homeowner, want to insure yourself against the financial consequences of the house burning down.

For this you pay a premium to the insurance company (whether the house burns or not), and the insurance company pays you money, should your house burn down.

In the securities market, the most common risk or insurance products – depending on which side of the deal you are on – are options and futures.

If you are going to trade in derivatives, you must sign special agreements just for this.

What is required for “ordinary” securities trading is therefore not enough. Your investment firm must also specifically inform you about the risks of derivatives trading.

Brokerage on derivatives trading

For ordinary stock trading, you have to pay a fee to get your trades done. This fee is called brokerage.

When you trade options, you usually have to pay a commission to your securities company and a clearing fee to Nasdaq. Pricing is free, so you should compare what it costs with different securities companies.

You can count on the percentage being more expensive to trade in options than in shares.

Derivatives: Options and futures

Options and futures are two different variants of derivatives. If you are going to invest in any of these variants, it is important that you understand the risks and requirements for yourself as an investor.

Derivatives that require collateral

Issued options and futures are examples of derivatives that require you to provide security, for example in the form of money in an account.

The reason why a security is required is that the price of options and futures can vary greatly.

The requirement for security also means that you must always be prepared to push for new collateral if the need arises. This means that you need to monitor your investment daily or even more often.

If you do not have sufficient security for your commitment, you risk that your positions will be closed, ie the options or futures will be sold, at a time that you have not chosen yourself and which is unfavorable to you.

Derivative options

An option is a type of derivative. The value of a derivative depends on the value of an underlying asset.

The most common underlying assets in an option are shares, bonds, commodities, currencies and various forms of indices.

When you have invested in an option, you have either a right or obligation to buy or sell at a certain price for a certain given time, depending on whether you have invested in a call or put option.

An option is also a contract that gives you who bought the option the right but not the obligation, in the future, either for a certain period of time or at a future time, to buy or sell the underlying asset, at a predetermined price.

The person who sold the option is obliged to buy or sell the underlying asset, either when you so wish for a certain period of time (American option) or on the option’s end date (European option).

Options are usually traded in so-called contracts that consist of 100 underlying assets, such as 100 shares.

To invest in an option, you first pay a premium to get a certain right or obligation. When you buy an option, you then have the right to buy or sell the underlying asset at a certain price.

Through it, there is a large leverage in options that can quickly yield large gains or losses.

Options can be used in various strategies to “insure” a certain profit with a share. In order to do this, you need to know how an option works and what risks you are taking.

Derivative futures

A future is a type of derivative. The value of a derivative depends on the value of an underlying asset. The most common underlying assets in a future are stocks, bonds, commodities, currencies and various forms of indices.

The holder of a future may not request to redeem the semester during the term.

Both the person exhibiting the future and the holder of the future are obliged to complete the transaction when the term ends.

Options and futures have a high risk

Investing in options and futures requires significantly more of you than investing in stocks.

In addition to knowledge of what you have invested in and that you have time to follow the development of your investment, you also need to understand the more complicated relationship between return and risk.

Options trading can provide opportunities for high returns, but the risks are significantly higher than with direct purchases of underlying assets.

You could lose all your invested capital. If you are considering options trading, it is very important that you understand what options trading entails.

Conclusion / Summary

What you need to know about derivatives…

Derivatives can be linked to price movements in assets, such as shares, bonds, currencies or interest rates.

But they can also be linked to inflation, property prices and in some cases even weather!

In short, there are three different types of derivatives: futures contracts, including forward contracts, and option contracts.

Forward and forward contracts are essentially the same, except that the latter is expected to run until the delivery of the asset in question, while the former does not.

Forward and forward contracts are an agreement to purchase an asset at a set price on a set date.

All options give the right to the same thing, but do not require you to do it that way.

Swaps are not technically derivatives, but are largely considered as such. They involve the exchange of financial instruments.

CFDs (CFDs) have many of the characteristics of the derivative, in that they allow traders to take a position for an underlying asset.

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Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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