Derivatives are financial securities that derive their value from an underlying asset, such as stocks, bonds, currencies, interest rates, commodities, or market indexes. They can be powerful tools for hedging risk, speculating, and capitalizing on market trends. However, derivatives also come with substantial risks if used improperly.
This comprehensive guide provides an in-depth look at derivatives trading and investing for individuals. It covers:
- What derivatives are and how they work
- Common types of derivatives contracts
- The risks and rewards of trading derivatives
- Derivatives trading strategies
- How to get started trading options and futures
- Frequently asked questions
Whether you’re an experienced trader looking to expand your knowledge or a beginner wanting to learn the derivatives market, this guide has the information you need.
What Are Derivatives and How Do They Work?
A derivative is a contract between two parties that derives its value from an underlying asset. The underlying asset could be a stock, bond, currency, commodity, interest rate, market index, or another derivative.
For example, an options contract gets its value from the price movements of the stock it represents. One party agrees to sell the stock to the other party at a predetermined “strike” price if the option is exercised before the expiration date.
Here are a few key characteristics of derivatives:
- Their value is tied to the price fluctuations of the underlying asset
- They allow parties to speculate on prices or hedge against losses
- A small position controls a much larger amount of the underlying asset
- They have expiration dates after which the derivative ceases to exist
- They are often traded on exchanges but also over-the-counter (OTC)
Parties trade derivatives to transfer price risk or to potentially profit from favorable price movements. Their use can also increase costs for the end consumers of commodities and other assets if speculation contributes to higher prices.
Types of Derivatives
Many different derivatives contracts exist, but here are some of the most common:
Futures Contracts
A futures contract obligates the buyer to purchase an asset and the seller to sell an asset at a predetermined future date and price. The contracts detail the quality and quantity of the underlying asset.
Futures trade on exchanges, are standardized by an oversight body, and must be settled once they expire. Traders deposit collateral known as initial margin, and positions are marked-to-market daily, meaning profits and losses are calculated at the end of each trading session.
Examples include futures on the S&P 500 index, crude oil, gold, and U.S. Treasury Bonds. Investors and commercial users employ futures to speculate and to hedge commodity, currency, and interest rate risk.
Forwards
Forwards are similar to futures but do not trade on centralized exchanges and are not standardized. They trade over-the-counter (OTC) directly between two counterparties. These customized contracts lack regulation, have less transparency, and involve greater counterparty risks.
Examples include currency forwards used by multinational corporations for hedging exchange rate exposure.
Options Contracts
Options give buyers the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset by the expiration date at a pre-determined price. Sellers take the opposite side of traded options. Options have expiration dates and trade on exchanges like stocks.
Examples include options on stocks, stock indexes, and stock index futures. Buyers pay a premium upfront and risk losing it if options expire worthless. Sellers collect premiums upfront in exchange for obligating themselves to buy or sell shares if assigned by buyers.
Options facilitate speculation and hedging. Investors use strategies like covered calls, protective puts, and spreads to profit in particular price environments for the underlying assets.
Swaps
Swaps are agreements between counterparties to exchange cash flows over time. They trade OTC, so terms can be customized between parties.
Examples include interest rate swaps, currency swaps, and credit default swaps. Swap users can exchange fixed cash flows for floating ones, currencies can be swapped across countries, and credit risk can be transferred between parties.
Benefits and Risks of Derivatives Trading
Trading derivatives instead of the underlying asset has advantages and disadvantages:
Benefits
- Leverage: A small amount of capital controls a larger position size and exposure to price movements.
- Hedging: Derivatives allow the transfer of asset price risk from one party to another.
- Speculation: Traders can use derivatives to bet on expected moves higher or lower.
- Cost-Effective: Commission costs can be lower for derivatives than trading the underlying asset outright.
- Customization: OTC derivatives can be tailored to meet specific business needs.
Using leverage allows traders to put a relatively small amount of capital at risk to earn potentially substantial returns from large swings in asset prices. Hedgers give up some upside if prices move in their favor in exchange for limiting losses if prices move against them.
Risks
- Losses: The high leverage of derivatives can lead to outsized losses fast if prices go the wrong way.
- Complexity: Valuing derivatives involves calculating time value, volatility, interest rates, and other variables.
- Counterparty: OTC derivatives carry risk if the counterparty defaults on the contract terms.
- Systemic: Interconnected webs of derivatives pose risks to the overall financial system.
The complexity of derivatives requires a thorough understanding of their characteristics and risks before trading. Even experienced investors can get burned by the aggressive leverage involved. Always practice sound risk management with any derivative instrument.
Trading Strategies Using Derivatives
If used properly, derivatives trading strategies can enhance portfolio returns and hedge against losses. Here are a few effective approaches:
Covered Call Writing
Investors write (or sell) calls against stock already owned to earn premium income. If exercised, they must sell shares at the strike price to call buyers willing to pay more. The investor sacrifices some upside if shares rise steeply but earns income reducing downside exposure.
Protective Puts
Buying protective puts allows investors to hedge downside in stocks they own or plan to own. Puts give buyers the right to sell at the strike price even if shares fall steeply. The put premium spent protects against losses but reduces potential upside earned if shares rally.
Bull Call Spreads
Buying in-the-money calls while selling lower strike, out-of-the-money calls further out reduces spread costs but offers upside if shares rally moderately. Maximum gains are earned if shares expire between strikes at the spread’s expiration. The risk is limited to the net premium paid.
Bear Put Spreads
This strategy involves the purchase of in-the-money puts and sale of lower strike puts to reduce net costs while benefiting from a modest fall in the underlying shares. Maximum profits occur if shares fall to between the strike prices when the spread expires. Risk is limited to the initial net premium outlay.
Iron Condors
Iron condors use four legs and both calls and puts to capitalize on low volatility in the underlying shares. Traders sell an out-of-the-money call spread and put spread with the short strikes above and below current prices and closer to each other than the lower and higher long strike prices. Maximum gains occur if shares expire between the short strikes. Risks are limited to the difference between strike widths less net credit received.
Straddles
Straddles combine the purchase (or sale) of both a call and put with the same expiration date and strike price when investors expect volatility but are unsure of direction. Large share price movements lead to gains from the profitable side of the straddle. The breakeven point depends on combined premiums paid for both options and strike price distance from current prices.
Getting Started Trading Derivatives
Investors looking to trade derivatives have a few options to consider:
Trade Options
New traders should start with stock options to understand risk-reward dynamics. Leading online brokers like Charles Schwab, Fidelity, E*Trade, and TD Ameritrade offer tools helping newcomers select options strategies fitting their outlook and risk tolerance. Most brokers offer virtual trading and education helping accelerate experience. Options offer flexibility for short-term traders and investors seeking income or downside protection.
Open a Futures Account
Futures trading requires solid capital, trading experience, and risk tolerance. Brokers like Interactive Brokers and TD Ameritrade offer individual futures accounts with mobile access, analytics, and risk management tools. Traders deposit initial margin allowing the purchase of contracts representing exposure to markets like energies, metals, agriculture, currencies, and indexes. Ongoing research, disciplined trade plans, and strict risk controls are vital for successfully trading futures long-term.
Try a Derivatives ETF
Exchange-traded funds (ETFs) tracking derivatives indexes offer simple ways to gain broad commodity, currency, and volatility exposure without directly holding futures. Consider funds like Invesco DB Commodity Index Tracking (DBC) or iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX) to capitalize on entire markets moving potentially. Still, research how these complex funds work before investing.
The Final Word on Derivatives Trading
Derivatives serve valuable purposes but also pose risks if used improperly. Educating yourself extensively, starting slowly, managing risk carefully, and working with a reputable broker are keys to success.
With patience and practice, derivatives like basic options contracts can offer beginners introductory trading experience. As skills improve, more complex futures, commodities, and alternatives may be considered.
Investors able to withstand substantial volatility can use certain derivatives to speculate and hedge in alignment with current market expectations. Just be sure to weigh potential rewards against assumed risks.
Handle derivatives trading with care and respect these powerful instruments. But used prudently, they can also enhance portfolio returns and provide insurance against unexpected price swings.
Frequently Asked Questions
What are the main benefits of trading derivatives?
The main benefits include leverage that allows controlling large dollar amounts for less capital and hedging to transfer risk from one party to another. Speculation and lower costs than trading the asset outright may also be advantages.
What risks should I watch out for with derivatives?
Be aware of counterparty risks with OTC derivatives if the other party defaults. The high leverage involved also leads to accelerated losses if trades move against investors. Derivatives tend to carry more complexity in valuation and risks that should be fully understood before trading.
What derivatives are best for beginners to start trading?
Beginners should start with basic stock options which carry defined and limited risks. As experience develops, futures contracts, commodities, currencies, and other derivatives may be considered. Advanced options strategies also involve substantial risks as well.
How much money do I need to trade derivatives?
Required capital varies widely depending on the products traded and strategies used. Options can be traded with account minimums under $500 at some basic brokers. Futures may require at least $5,000 to start and potentially much more depending on products, the number of contracts, and leverage used.
Should I use derivatives to hedge my portfolio?
Portfolio hedging can be prudent for large investors concerned about substantial losses. But hedging costs via options and other derivatives reduce potential gains in favorable markets. Weigh costs versus benefits and align strategies with your personal risk tolerance.
In another related article, Understanding Investment Income: A Comprehensive Guide
