Investing has become much more complicated over the past decades as various types of derivative instruments become created. But if you think about it, the use of derivatives has been around for a very long time, particularly in the farming industry. One party agrees to sell a good and another party agrees to buy it at a specific price on a specific date. Before this agreement occurred in an organized market, the bartering of goods and services was accomplished via a handshake.

SEE: The Barnyard Basics Of Derivatives

The type of investment that allows individuals to buy or sell the option on a security is called a derivative. Derivatives are types of investments where the investor does not own the underlying asset, but he or she makes a bet on the direction of the price movement of the underlying asset via an agreement with another party. There are many different types of derivative instruments, including options, swaps, futures and forward contracts. Derivatives have numerous uses as well as various risks associated with them, but are generally considered an alternative way to participate in the market.

A Quick Review of Terms
Derivatives are difficult to understand partly because they have a unique language. For instance, many instruments have a counterparty, who is responsible for the other side of the trade. Each derivative has an underlying asset for which it is basing its price, risk and basic term structure. The perceived risk of the underlying asset influences the perceived risk of the derivative.

Pricing is also a rather complicated variable. The pricing of the derivative may feature a strike price, which is the price at which it may be exercised. When referring to fixed income derivatives, there may also be a call price which is the price at which an issuer can convert a security. Finally, there are different positions an investor can take: a long position means you are the buyer and a short position means you are the seller.

How Derivatives Can Fit into a Portfolio
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 against or insure the risk of an asset. For example if you own shares of a stock and you want to protect against the chance that the stock's price will fall, then you may buy a put option. In this case, if the stock price rises you gain because you own the shares and if the stock price falls, you gain because you own the put option. The potential loss from holding the security is hedged with the options position.

Leverage can be greatly enhanced by using derivatives. Derivatives, specifically options are most valuable in volatile markets. When the price of the underlying asset moves significantly in a favorable direction, then the movement of the option is magnified. Many investors watch the VIX (Chicago Board Options Exchange Volatility Index) which measures the volatility of the S&P 500 Index options. High volatility increases the value of both puts and calls.

Speculating is a technique when investors bet on the future price of the asset. Because options offer investors the ability to leverage their positions, large speculative plays can be executed at a low cost

Derivatives can be bought or sold in two ways. Some are traded over-the-counter (OTC) while others are traded on an exchange. OTC derivatives are contracts that are made privately between parties such as swap agreements. This market is the larger of the two markets and is not regulated. Derivatives that trade on an exchange are standardized contracts. The largest difference between the two markets is that with OTC contracts, there is counterparty risk since the contracts are made privately between the parties and are unregulated, while the exchange derivatives are not subject to this risk due to the clearing house acting as the intermediary.

There are three basic types of contracts-options, swaps and futures/forward contracts- with variations of each. Options are contracts that give the right but not the obligation to buy or sell an asset. Investors typically will use option contracts when they do not want to risk taking a position in the asset outright, but they want to increase their exposure in case of a large movement in the price of the underlying asset. There are many different option trades that an investor can employ, but the most common are:

  • Long Call - If you believe a stock's price will increase, you will buy the right (long) to buy (call) the stock. As the long call holder, the payoff is positive if the stock's price exceeds the exercise price by more than the premium paid for the call.
  • Long Put - If you believe a stock's price will decrease, you will buy the right (long) to sell (put) the stock. As the long put holder, the payoff is positive if the stock's price is below the exercise price by more than the premium paid for the put.
  • Short Call - If you believe a stock's price will decrease, you will sell or write a call. If you sell a call, then the buyer of the call (the long call) has the control over whether or not the option will be exercised. You give up the control as the short or seller. As the writer of the call, the payoff is equal to the premium received by the buyer of the call if the stock's price declines, but if the stock rises more than the exercise price plus the premium, then the writer will lose money.
  • Short Put - If you believe the stock's price will increase, you will sell or write a put. As the writer of the put, the payoff is equal to the premium received by the buyer of the put if the stock price rises, but if the stock price falls below the exercise price minus the premium, then the writer will lose money.

Swaps are derivatives where counterparties to exchange cash flows or other variables associated with different investments. Many times a swap will occur because one party has a comparative advantage in one area such as borrowing funds under variable interest rates, while another party can borrow more freely as the fixed rate. A "plain vanilla" swap is a term used for the simplest variation of a swap. There are many different types of swaps, but three common ones are:

  • Interest Rate Swaps - Parties exchange a fixed rate for a floating rate loan. If one party has a fixed rate loan but has liabilities that are floating, then that party may enter into a swap with another party and exchange fixed rate for a floating rate to match liabilities. Interest rates swaps can also be entered through option strategies. A swaption gives the owner the right but not the obligation (like an option) to enter into the swap.
  • Currency Swaps - One party exchanges loan payments and principal in one currency for payments and principal in another currency.
  • Commodity Swaps - This type of contract has payments based on the price of the underlying commodity. Similar to a futures contract, a producer can ensure the price that the commodity will be sold and a consumer can fix the price which will be paid.

Forward and future contracts are contracts between parties to buy or sell an asset in the future for a specified price. These contracts are usually written in reference to the spot or today's price. The difference between the spot price at time of delivery and the forward or future price is the profit or loss by the purchaser. These contracts are typically used to hedge risk as well as speculate on future prices. Forwards and futures contracts differ in a few ways. Futures are standardized contracts that trade on exchanges whereas forwards are non-standard and trade OTC.

SEE: Tips For Getting Into Futures Trading

The Bottom Line
The proliferation of strategies and available investments has complicated investing. Investors who are looking to protect or take on risk in a portfolio can employ a strategy of being long or short underlying assets while using derivatives to hedge, speculate or increase leverage. There is a burgeoning basket of derivatives to choose from, but the key to making a sound investment is to fully understand the risks - counterparty, underlying asset, price and expiration - associated with the derivative. 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 portfolio strategy.

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