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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 and improve returns has been around for generations, particularly in the farming industry, where one party to a contract agrees to sell goods or livestock to a counter-party 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.

The simplest derivative investment allows individuals to buy or sell an option on a security. The investor does not own the underlying asset but he or she makes a bet on the direction of price movement via an agreement with counterparty or exchange. There are many types of derivative instruments, including options, swaps, futures and forward contracts. Derivatives have numerous uses while incurring various levels of risks but are generally considered a sound way to participate in the financial markets.

A Quick Review of Terms

Derivatives are difficult for the general public to understand partly because they have a unique language. For instance, many instruments have counterparties who are taking the other side of the trade. Each derivative has an underlying asset that dictates its pricing, risk and basic term structure. The perceived risk of the underlying asset influences the perceived risk of the derivative.

The pricing of the derivative may feature a strike price, which is the price at which it may be exercised. There may also be a call price with fixed income derivatives, 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 postilion, 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

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 to insure the risk of an asset. For example, the owner of a stock buys a put option if he or she wants to protect the portfolio against a decline. This shareholder makes money if the stock rises but also gains, or loses less money, if the stock falls because put option pays off. 

Derivatives can greatly increase leverage. Leveraging through options works especially well in volatile markets.when the price of the underlying asset moves significantly and in a favorable direction because options will magnify this movement. Many investors watch the Chicago Board Options Exchange Volatility Index (VIX) to measure potential leverage because it also predicts volatility of S&P 500 Index options. For obvious reasons. high volatility can increase the value and cost of both puts and calls.

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 underlying asset.  

Trading Derivatives

Derivatives can be bought or sold in two ways: 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 while derivatives that trade on an exchange are standardized contracts. There is counterparty 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: options, swaps and futures/forward contracts - with many variations of each type. Options are contracts that give 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 to increase exposure in case of large price movement.

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

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

Swaps are derivatives where counterparties exchange cash flows or other variables associated with different investments. Many times a swap will occur 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 a floating rate loan. If one party has a fixed rate loan but has floating rate liabilities, he or she may enter into a swap with another party and exchange fixed rate for a floating rate to match liabilities. Interest rate swaps can also be entered through option strategies while a swaption gives the owner the right but not the obligation 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 - A contract where party and counterparty 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 most current price. The purchaser's profit or loss is calculated by the difference between the spot price at 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 over the counter.

The Bottom Line

Investors looking to protect or assume risk in a portfolio can employ long, short or neutral derivative strategies that seek 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.

SEE: The Barnyard Basics Of DerivativesTips For Getting Into Futures Trading

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