Derivatives sound like a complicated term used only by mathematicians and market analysts. Little did we know that we’re already dealing with some form of derivatives in our daily transactions.

What Are Derivatives?

A derivative is a form of contract which represents a trade of assets between two or more parties. The value of the underlying assets determines the value of the contract. Typically, the assets involved are stocks, commodities, interest rates, indices, bonds, and currencies.

Derivatives can be traded on an exchange or over-the-counter (OTC) channels. OTC contracts are more abundant compared to those traded in regulated exchange markets. However, since they’re unregulated, higher risks are involved in trading them.

Derivatives, back then, were used to ensure that internationally traded goods follow a fair exchange rate. They’re used to bridge the value difference between two currencies. Nowadays, derivatives are used in a wider variety of transactions.

How do Derivatives Work?

Derivatives work by having two or more parties agree to trade (or optionally trade) an asset at a specified value and at a given time. A certain party may profit from trading it if it goes along with their bias, similar to how one benefits from stock market trading.

Derivatives pertain to multiple forms of security. There are three kinds mainly used in market transactions: (1) futures contracts, (2) options, and (3) swaps.

• Futures Contract

This is probably the most traded type among derivatives. Futures contract basically involves a deal between 2 parties regarding the trade of an asset which is to be completed at an agreed price and time in the future.

For example, let’s say you’re holding Stock A with a current value of AU$ 10 per share. You have a feeling it will go down a year from now but you don’t want to sell it yet for its dividends. Your friend, on the other hand, thinks the price will increase by at least 50% by next year.

With this, you decided to arrange a futures contract with your friend to protect the value of your asset based on your bias that the price will dive down. Your friend agreed to buy all of your shares at AU$ 10 per share (which is its current price), whatever its new price may be the following year.

Now, two things may happen. The first is your bias gets confirmed and prices dive down. This way, you’ve protected your assets because your friend will still have to buy the same stock for AU$ 10 even if its new value is way below that. The second scenario is when prices go up against your bias. This will make your friend profitable for buying your shares at a cheaper price compared to its current market value.

• Options

It’s somewhat similar to a futures contract because it involves an agreement to trade a security at a specific price and date in the future. The main difference between futures and options is that the latter doesn’t oblige either of the parties to make the transaction, hence the term ‘option’.

For example, you contracted a farmer to sell you a dozen chickens a few days before the holiday season. However, you’re not sure the farmer can deliver the chickens on the said date due to high demand. To make sure you get your order, you contracted another farmer and offered them an option to sell you a dozen chickens in case the first farmer fails to deliver the chickens on time. With this, you protected yourself from not having your order fulfilled since you made a contingency plan through an option.

Options are often used in hedging funds to prevent loss of capital or revenue.

• Swaps

Swaps involve an agreement to trade the loan terms of two parties. It’s usually utilized to trade one with a fixed interest rate for another one that has a variable rate, or vice versa. The goal of swaps is for involved parties to either gain leverage on the fluctuating interest rates or make it easier to repay the loan by having a fixed interest rate.

Swaps are traded OTC. This means the two parties have more freedom to customize the swap deal to their advantage.

In the Australian Stock Exchange (ASX) there are also products that involve grain derivatives and energy derivatives which you can trade on the market. The concept remains the same and the only thing that differs them from other derivatives is the type of the underlying asset being evaluated.

Conclusion

Investing in derivatives can be rewarding, although it also imposes a high risk to involved parties. It can be included as part of your portfolio diversification strategy but you should also be aware of the risks you’re taking in trading them.

You should study the value of the underlying asset, its price movement, the counterparty’s reason for trading it, and the expiration of the agreement if you want to invest in derivatives.