Derivatives 101

Investing has grown more complicated in recent decades with the creation of numerous derivative instruments offering new ways to manage money. The use of derivatives to hedge risk or improve returns has been around for generations, particularly in the farming industry.

In such an instance, one party to a contract agrees to sell goods or livestock to a counterparty who agrees to buy those goods or livestock at a specific price on a specific date. This contractual approach was revolutionary when first introduced, replacing the simple handshake.

Option contracts are the simplest derivative investment. Their value is tied to the value of the contract's underlying security. Options give a buyer the opportunity to buy or sell the underlying security. The investor does not own the underlying asset but they make a bet on the direction of its price movement.

There are many types of derivative instruments, including options, swaps, futures, and forward contracts. Derivatives have numerous uses and various levels of risks but are generally considered a sound way to participate in the financial markets.

A Quick Review of Terms

Derivatives can be difficult for the general public to understand partly because they involve unfamiliar terms. For instance, many instruments have counterparties who take the other side of the trade.

Each derivative has an underlying asset that dictates its pricing, risk, and basic term structure. The underlying asset can be anything from stocks and bonds to commodities or even economic indicators. The perceived risk of the underlying asset influences the perceived risk of the derivative.

The structure of the derivative may feature a strike price. This is the price at which it may be exercised. Fixed income derivatives may have a call price, which signifies the price at which an issuer can convert a security.

Many derivatives force the investor to take a bullish stance with a long position, a bearish stance with a short position, or a neutral stance with a hedged position that can include long and short features.

How Derivatives Can Fit Into a Portfolio

Hedge to Protect Value

Investors typically use derivatives for three reasons—to hedge a position, to increase leverage, or to speculate on an asset's movement. Hedging a position is usually done to protect or insure against the adverse price movement risk of an asset.

For example, the owner of a stock buys a put option on that stock to protect their portfolio against a decline in the price of the stock. In other words, they take opposite positions on the same security.

The strategy is that if prices decline and they lose money on the stock, they will simultaneously make money on the put option (since the put should gain in value). This gain can offset the drop in the value of their stock.

On the other hand, if the stock price rises as hoped, the shareholder makes money on the appreciation in value of the stock in their portfolio. However, they also lose money on the premium paid for the put option. 

A shareholder who hedges understands that they could make more money without paying for the insurance offered by a derivative if prices move favorably. However, if prices move against them, the hedge is in place to limit their loss.

The Power of Leverage

Derivatives can greatly increase leverage. For derivatives, leverage refers to the opportunity to control a sizable contract value with a relatively small amount of money. Leveraging through options works especially well in volatile markets. When the price of the underlying asset moves significantly and in a favorable direction, options magnify this movement.

Many investors watch the CBOE Volatility Index (VIX) to measure potential leverage because it also predicts the volatility of S&P 500 index options. High volatility can increase the value and cost of both puts and calls.

Speculation

Investors also use derivatives to bet on the future price of the asset through speculation. Large speculative plays can be executed cheaply because options offer investors the ability to leverage their positions at a fraction of the cost of an equivalent amount of underlying asset.

Trading Derivatives

Derivatives can be bought or sold over-the-counter (OTC) or on an exchange. OTC derivatives are contracts that are made privately between parties, such as swap agreements, in an unregulated venue.

On the other hand, derivatives that trade on an exchange are standardized contracts. There is counter-party risk when trading over the counter because contracts are unregulated, while exchange derivatives are not subject to this risk due to clearing houses acting as intermediaries.

Types of Derivatives

There are three basic types of contracts. These include options, swaps, and futures/forward contracts. All three have many variations. Options are contracts that give investors the right but not the obligation to buy or sell an asset. Investors typically use option contracts when they don't want to take a position in the underlying asset but still want exposure in case of large price movements.

There are dozens of options strategies, but the most common include:

• Long call: You believe a security's price will increase. You buy (go long) the right to own (call) the security. As the long call holder, the payoff is positive if the security's market price exceeds the exercise price by more than the premium paid for the call.
• Long put: You believe a security's price will decrease. You buy (go long) the right to sell (put) the security. As the long put holder, the payoff is positive if the security's market price is below the exercise price by more than the premium paid for the put.
• Short call: You believe a security's price will decrease. You sell (write) a call. If you sell a call, the counter-party (the holder of the call) has control over whether or not the option will be exercised. As the writer of the call, your payoff is equal to the premium received from the buyer of the call. However, you face losses if the security's market price rises above the the exercise price. The premium you received would partially offset this loss.
• Short put: You believe the security's price will increase. You sell (write) a put. As the writer of the put, your payoff is equal to the premium received from the buyer of the put. However, you face losses if the security's market price falls below the exercise price. The premium you received would partially offset this loss.

Swaps are derivatives where counter-parties exchange cash flows or other variables associated with different investments. A swap occurs because one party has a comparative advantage, like borrowing funds under variable interest rates, while another party can borrow more freely at fixed rates. The simplest variation of a swap is called plain vanilla but there are many types, including:

• Interest rate swaps: Parties exchange a fixed-rate loan for one with a floating rate. If one party has a fixed-rate loan but has floating rate liabilities, they may enter into a swap with another party and exchange their fixed rate for a floating rate to match liabilities. Interest rate swaps can also be entered through option strategies. A swaption gives the owner the right but not the obligation to enter into the swap.
• Currency swaps: One party exchanges loan payments and potentially principal in one currency for payments and potentially principal in another currency.
• Commodity swaps: A contract where party and counter-party agree to exchange cash flows, which are dependent on the price of an underlying commodity.

Parties in forward and future contracts agree to buy or sell an asset in the future for a specified price. These contracts are usually written using the spot or the most current price.

The purchaser's profit or loss is calculated by the difference between the spot price at the time of delivery and the forward or future price. These contracts are typically used to hedge risk or to speculate. Futures are standardized contracts that trade on exchanges while forwards are non-standard, trading OTC.

Frequently Asked Questions

The Bottom Line

Investors looking to protect or assume risk in a portfolio can employ long, short, or neutral derivative strategies to hedge, speculate, or increase leverage.

The use of a derivative only makes sense if the investor is fully aware of the risks and understands the impact of the investment within a broader portfolio strategy.