Derivatives vs. Options: An Overview
A derivative is a financial contract that gets its value, risk, and basic term structure from an underlying asset. Options are one category of derivatives and give the holder the right, but not the obligation to buy or sell the underlying asset. Options are available for many investments including equities, currencies, and commodities.
Derivatives are contracts between two or more parties whereby its value is based on an agreed-upon underlying security or set of assets such as the S&P index. Typical underlying securities for derivatives include bonds, interest rates, commodities, market indexes, currencies, and stocks.
Derivatives have a price and an expiration date or settlement date, which can be in the future. As a result, derivatives, including options, are often used as hedging vehicles to offset the risk associated with an asset or portfolio.
Derivatives have been used to hedge risk for many years in the agricultural industry, where one party can make an agreement to sell crops or livestock to another counterparty who agrees to buy those crops or livestock for a specific price on a specific date. These bilateral contracts were revolutionary when first introduced, replacing oral agreements and the simple handshake.
- Derivatives are contracts between two or more parties whereby its value is based on an agreed-upon underlying security or set of assets.
- Derivatives include swaps, futures contracts, and forward contracts.
- Options are one category of derivatives and give the holder the right, but not the obligation to buy or sell the underlying asset.
- Options, like derivatives, are available for many investments including equities, currencies, and commodities.
When most investors think of options, they usually think of equity options, which is a derivative that obtains its value from an underlying stock. An equity option represents the right, but not the obligation, to buy or sell a stock at a certain price, known as the strike price, on or before an expiration date. Options are sold for a price called the premium. A call option gives the holder the right to buy the underlying stock while a put option gives the holder the right to sell the underlying stock.
If the option is exercised by the holder, the seller of the option must deliver 100 shares of the underlying stock per contract to the buyer. Equity options are traded on exchanges and settled through centralized clearinghouses, providing transparency and liquidity, two critical factors when traders or investors take derivatives exposure.
American-style options can be exercised at any point up until the expiration date while European-style options can only be exercised on the day it is set to expire. Major benchmarks, including the S&P 500, have actively traded European-style options. Most equity and exchange-traded funds (ETFs) options on exchanges are American options while just a few broad-based indices have American-style options. Exchange-traded funds are a basket of securities—such as stocks—that track an underlying index.
Futures contracts are derivatives that obtain their value from an underlying cash commodity or index. A futures contract is an agreement to buy or sell a particular commodity or asset at a preset price and at a preset time or date in the future.
For example, a standard corn futures contract represents 5,000 bushels of corn, while a standard crude oil futures contract represents 1,000 barrels of oil. There are futures contracts on assets as diverse as currencies and the weather.
Another type of derivative is a swap agreement. A swap is a financial agreement among parties to exchange a sequence of cash flows for a defined amount of time. Interest rate swaps and currency swaps are common types of swap agreements. Interest rate swaps, for example, are agreements to exchange a series of interest payments for another based off a principal amount. One company might want floating interest rate payments while another might want fixed rate payments. The swap agreement allows two parties to exchange the cash flows.
Swaps are generally traded over the counter but are slowly moving to centralized exchanges. The financial crisis of 2008 led to new financial regulations such as the Dodd-Frank Act, which created new swaps exchanges to encourage centralized trading.
There are multiple reasons why investors and corporations trade swap derivatives. The most common include:
- A change in investment objectives or repayment scenarios.
- A perceived financial benefit in switching to newly available or alternative cash flows.
- The need to hedge or reduce risk generated by a floating rate loan repayment.
A forward contract is a contract to trade an asset, often currencies, at a future time and date for a specified price. A forward contract is similar to a futures contract except that forwards can be customized to expire on a particular date or for a specific amount.
For example, if a U.S. company is due to receive a stream of payments in euros each month, the amounts must be converted to U.S. dollars. Each time there's an exchange, a different exchange rate is applied given the prevailing euro-to-U.S. dollar rate. As a result, the company might receive different dollar amounts each month despite the euro amount being fixed because of exchange rate fluctuations.
A forward contract allows the company to lock in an exchange rate today for every month of euro payments. Each month the company receives euros, they are converted based on the forward contract rate. The contract is executed with a bank or broker and allows the company to have predictable cash flows.
A forward contract can be used for speculation as well as hedging, although its non-standardized nature makes it particularly apt for hedging. Forward contracts are traded over the counter, meaning between banks and brokers, since they are custom agreements between two parties. Since they're not traded on an exchange, forwards have a higher risk of counterparty default. As a result, forward contracts are not as easily available to retail traders and investors as futures contracts.
One of the main differences between options and derivatives is that option holders have the right, but not the obligation to exercise the contract or exchange for shares of the underlying security. Derivatives, on the other hand, usually are legal binding contracts whereby once entered into, the party must fulfill the contract requirements. Of course, many options and derivatives can be sold before their expiration dates, so there's no exchange of the physical underlying asset. However, for any contract that's unwound or sold before its expiry, the holder is at risk for a loss due to the difference between the purchase and sale prices of the contract.