Derivative investments are widely misunderstood. They seem to have an undeserved reputation for being sinister portfolio killers that wreak economic havoc on the side.
They have been blamed for the 2008 financial crisis and for the 1987 stock market crash. They are not independent actors; they can’t crash anything. They do not create additional risk — they transfer risk from one party to another, perhaps from multiple parties to other multiple parties. The reality is they are contracts based on an underlying asset, index, or other security.
Derivatives are not something new that appeared on the scene in the last couple of decades. They didn’t emerge from the dark underbelly of the financial netherworld to take money from average investors. They have — and still do — perform a valuable service.
How Derivative Investments Work
A derivative is a contract between two or more parties. The contract is based on an underlying asset, an index, or another security. The contract is derived from the underlying entity, hence the name. To keep things simple, the underlying item on which the contract is based is generally referred to simply as the underlying.
Derivates allow risk to be transferred between parties. Different parties both view and experience risk differently, and there is money to be made in the trade of the risks.
Derivatives can be used to hedge, or to leverage or speculate.Hedging offsets risk. If you hold a stock that you hope will increase in value, but you are worried that it might decrease in value, you can hedge the downside risk with a derivative investment.
You could buy an option to sell the stock in the future at a set price. If the stock increases as you hope it will, your gain is reduced by the cost of the option you don’t exercise. But if the stock declines dramatically, you can exercise your option to sell at the strike price in the contract, limiting your downside loss.
You have transferred the risk of the stock declining in value to the other party, the counterparty in your contract. You don’t make as much if the stock goes up because you have an additional cost of the option. You don’t lose as much if the stock goes down because you have protected yourself with the option. You have reduced your risk.
You can use options for leverage. The cost of an option to purchase a security in the future is less than the cost of actually purchasing the security now. You can purchase the option to purchase the security in the future and get a lot more for your money. If the price declines or doesn’t go up, you won’t exercise the option and you’re out your investment — all of it.
If the price goes up dramatically, you stand to gain many times your investment — you’ve leveraged your return.
Speculation is similar to leverage; both involve the assumption of risk. Speculation allows you to bet on a price movement either without buying the underlying security, or when you can’t actually purchase the underlying, such as an index.
Derivates aren’t limited to options. An option gives you the opportunity to buy or sell, but not an obligation to do so. Derivatives can also be used for swaps and for futures contracts.
Swaps allow parties to exchange similar underlying. Interest swaps could involve exchanging a fixed rate for a variable, with parties making the payments on the other’s debt to garner the perceived benefit of the other type of interest. Currency swaps allow for something to be paid in a different currency. Swaps are often two-party over-the-counter transactions.
Futures are exchange-traded contracts. You can purchase a contract to buy agricultural products and some others, including commodities, at a set price at a future time.
The market value of the underlying at that time will determine the value of your contract, whether you are in the money or out the money. Exchange-traded contracts are more regulated than over the counter contracts.
Derivatives’ Long History
Derivative investments have a long history. Farmers and agricultural business have used derivatives for a long time.
Farmers may want the assurance of a future price for their goods, forgoing some potential upside to guarantee at least a certain price. Other businesses may want to make sure they have a supply of the product. They are willing to forgo a potentially lower price to make sure they have a supply either for their own needs or for their customers.
Both parties give up some possible upside in exchange for reducing their risk.
The farmer may not make as much as they could have; they won’t get any more than the contract price. The purchaser gives up the potential opportunity to get a better price in exchange for reducing their risk of not being able to obtain what they need. Both benefit themselves by reducing risk.
Understanding the Risk of Derivatives
Derivatives neither directly create nor eliminate risk; they merely transfer it. In the example of the farmer who assures his future price with a contract, he has reduced his downside risk while giving up some upside potential. Because the purchaser has a different set of risk elements the purchaser may perceive that they have also lowered their risk; it is just a different risk that they were concerned about.
In some cases, such as options, the seller of the contract may assume greater risk in exchange for the premium they receive for the option.
In the case where our earlier shareholder purchased an option to sell a security in the future, the seller of the option needs to own that security (they’re long the security) to provide it for sale if the option is exercised.
Or if they do not own the security (they’re short the security), they would need to purchase it at that time to provide it for sale. The seller of the option is assuming the risk from the other party in exchange for the premium. There’s not any new risk being created in those scenarios.
There is the possibility to have very high risk in some derivative transactions. If you sell an option for a stock you don’t own, you may have to purchase that stock — at whatever the price is at that time — to cover the option if it is exercised. That can be a lot of risk. That is not a safe transaction for a novice investor; it’s not a safe transaction for many experienced investors.
Knowledge Is Key
Derivative investments allow investors to speculate on price movements of many different assets or other underlyings. They can be very simple or they can be quite complex. Their potential complexity is one reason novice investors are steered away from derivatives.
For simple derivative transactions, an investor can easily see what they are getting. Options can be straightforward. Futures can be straightforward. Understanding not only the upside but the potential downside of a transaction is essential.
Many investors wouldn’t want to invest in a contract in which they could potentially lose all of their money. Fewer would want to invest in a contract in which they could lose even more than that. When derivative investments become difficult for the investor to understand, they shouldn’t just walk away, they should run away.
For many investors, simple options — and in some cases futures — could help their overall portfolio returns if used carefully and sparingly.
That’s a lot to put on some people. They don’t want to spend the time to really understand what they are getting into. And that’s fine; just don’t get in. Derivatives become problematic when investors don’t understand the instrument or under-assess the risks that they are assuming.
But derivatives are not wreaking havoc on economies or crashing markets. They are doing what they are contractually obligated to do. For many investors, if used correctly, that means reducing risk.