Introduction to Derivatives: How They Work and How to Trade Them

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It seems nothing is guaranteed in the complex world of economics and finance. Prices rise and fall according to the whims of the market, and money changes hands countless times per second every day. In the midst of all this uncertainty, it makes sense why financial professionals would want to engineer a contract with values and timelines set in stone. A derivative is one common way in which this happens, although in many ways it only adds new layers of complexity to financial practice, rather than simplifying it.

Basic definitions and uses

At its core, though, derivatives are fairly uncomplicated and highly practical. The most basic form of a derivative is a mutual agreement between two parties to perform some kind of financial transaction at a specific time in the future and at a predetermined price. Based on this general definition, derivatives contracts are also often called futures, but variations on this theme apply to other forms including forward contracts, options, swaps and warrants. Derivatives can and have been used to exchange just about any kind of financial asset, including stocks, bonds, commodities, currencies, indexes and more. When traded as part of a future contract, these are considered the “underlying assets.”

Derivatives have a reputation for being obscure, but they are created and traded in large numbers all over the world. Some of the most common and familiar examples of derivatives include:

Stock options: As part of the employee or executive compensation package at some companies, workers may receive stock options that entitle them to the ownership of a predetermined amount of that company’s stock. Employee stock options cannot be traded on the open market, but stock options may be created and exchanged for publicly traded shares on an exchange.

Commodities: Most raw materials and natural resources, including crude oil, precious metals and crops are bought and sold in wholesale quantities using derivative contracts. This is useful because in many cases, extracting or producing natural resources on an industrial scale requires a large up-front investment of time and money.

Speculation: Financial firms like banks and insurance providers that make money through investment returns need to keep a highly diversified portfolio to survive. Creating and trading derivatives strategically helps them accomplish this goal through speculation, although the high risk involved in this concept means some rely on it more than others. By trading derivatives, investors may “hedge their bets” and gain some level of protection in case a certain investment loses value.

Derivatives in action

The commodities trade, sprawling as it is, may be one of the most relatable examples of how derivatives work. Imagine a simple business relationship between a grain farmer and a miller. The farmer needs to invest a lot of time and money to plant seeds, harvest the crop and prepare it for shipment. Meanwhile, the miller has orders to fill and has his own investments in expensive machinery to pay off. Both parties are also dealing with stiff competition from millions of other farmers and millers like them—if customers can find a lower price for the same product, they can always take their business elsewhere.

To deal with all of these outsized risks, the farmer and miller can draw up a contract derived from the market value of the grain. Before buying the seeds and planting them, the farmer can ask for a guaranteed price on his harvest from the miller. Likewise, the miller will agree to that price if he thinks grain will be worth about the same (or even more) once it is harvested months later. Both parties will set prices and contract conditions based on what they believe to be their best interest based on the market’s outlook. Perhaps scientists are forecasting a drought that could put the farmer’s crop in jeopardy — this might give the miller cause to demand a lower price as a hedge against that risk.

Getting started with trading

The combination of market volatility and uncertainty surrounding future events are the two major reasons why derivatives are often considered riskier investments than their underlying assets. While the realities of farming, mining and oil drilling often necessitate the use of futures and options contracts, casual investors or retirement savers don’t generally need to concern themselves with the derivatives market. If they want to dabble in hedging and speculation with derivatives, though, there are several ways to get started.

The average investor who wants to begin trading derivatives will need to do so through a broker. Since derivatives are considered a specialty or niche financial product for retail investors, those interested in trading them may need to do so through a brokerage that specializes in futures. These services vary in exactly what they provide customers as well as what they charge. NerdWallet explained that some brokerages may give tailored advice and research to investors, while others simply act as an entry point into the market. Brokerage fees on derivatives also vary from charging per trade or for a “round trip” that includes getting into and out of a contract.

Getting into derivatives by trading real contracts (and risking real money) might be too much for someone who is simply interested in the mechanics of the market. That’s why casual investors might consider trying out a virtual market instead, at least until they can get a handle on how derivatives work. Virtual markets use real-world data to create a simulated trading environment, allowing users to essentially perform the same tasks they would in the real derivatives market but without actually risking their savings.

The world of derivatives is far more complex than can be explained in a cursory introduction. Students in the Online Master of Science in Finance program from Northeastern University’s D’Amore-McKim School of Business can learn about all the inner workings of this fascinating financial universe along with many more concepts and skills they will find useful in their careers.

Recommended Readings:
Academic Program News and Updates
Pros and Cons of Index Funds

Sources: 

Northeastern University’s Online MSF Program