Next video:
Loading the player...

Investors use derivatives to hedge, speculate or increase their leverage, and there’s a growing basket of instruments to choose from. But it’s crucial that investors know the risks derivatives can pose for their portfolios.

A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party. It derives its value from the performance of the underlying asset, and the riskier that asset is, the riskier the derivative.

Investors typically use derivatives to hedge a position, for leverage, or to speculate. Hedging protects investors against an asset’s risk. For example, an investor may buy a put option on a stock she owns to protect against the chance the stock’s value will fall.

In volatile markets, an option can provide leverage, especially when the price of the underlying asset moves in a favorable direction. And speculating lets investors bet on an asset’s future price.

Derivatives are bought over the counter or on an exchange. An OTC derivative, which is made between two private parties, is unregulated and features counterparty risk.

Types of derivatives include options, swaps, and futures or forward contracts. Options provide the right to buy or sell an asset. They offer insurance against large price movements in an asset.

In swaps, counterparties exchange cash flows or other investments. Many times swaps occur because one party has access to better interest rates while the other party can borrow more freely as the fixed rate. Interest rate, currency and commodity swaps are common instruments.

Forward and future contracts are agreements to buy or sell an asset at a set price in the future. The difference in price provides one party in the deal a profit, and other a loss. Investors use them to hedge risk.

  1. No results found.
Related Articles
  1. Trading

    An Overview Of Futures, Derivatives, and Liquidity

    Gain an understanding of futures and derivatives, and how these instruments are meant to mitigate market risk.
  2. Trading

    Are Derivatives Safe For Retail Investors?

    These vehicles have gotten a bad rap in the press. Find out whether they deserve it.
  3. Investing

    Corporate Futures: Big Names, Big Risk

    We don't often think of Disney and derivatives, but it is one of many companies that use derivatives to hedge risks.
  4. Managing Wealth

    An In-Depth Look at the Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  5. Trading

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  6. Trading

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  7. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
  8. Trading

    Hedging with currency swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it with currency swaps.
  9. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  10. Trading

    Different Types of Swaps

    Identify and explore the most common types of swap contracts. Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific ...
Trading Center