Talking about derivatives can be daunting and a little bit intimidating. No matter how much you study about it or how much you try to understand it, there’s still an underlying feeling of uneasiness. This lack of confidence in derivatives may stem from its role in the 2008 financial crisis, or it may just be due to its different language.

Derivatives involve a lot of financial instruments. – this fact alone makes it very complicated. A derivative’s performance depends on another financial market’s performance because each derivative is composed of another asset on which it is bases its value. Whatever happens to its underlying asset affects the derivative itself.

What makes derivatives confusing is how it is also used to reduce risk. If used properly, derivatives can boost your investment portfolio and can be a really good hedging tool that will help you lessen risks.

How can I use derivatives in my portfolio?

There are three reasons for investors to use derivatives in their portfolios:

  1. If they want to hedge a position,
  2. if they want to increase their leverage, or
  3. if they want to speculate a certain price movement.

Hedging a position

If you hedge a position, this means that you want protection against the risk of a particular asset.

For example, you have shares of a stock that you think can be risky at this particular time. You want to protect your portfolio against the chances of this particular stock falling. In order to hedge your position, you are going to buy a derivative – a put option. Since you have a put option, these are the only things that can happen to you: if the stock’s value goes up, you gain because you have shares of that stock. If the stock’s value goes down, you still earn because you have a put option.

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Leveraging

With derivatives, your leverage can increase, especially in volatile markets. If the direction of an asset moves your way, the results are magnified because of your leverage.

Leverage, essentially, is borrowed capital. By increasing your leverage, you’re increasing the potential returns of an investment. A note of warning, though: it can also go the other way. Increasing leverage will also increase your potential losses.

Speculating

Speculating is for investors who like betting on possible prices of assets. Options and futures contracts offer investors the opportunity to pay for a certain asset on a specified date.

If done correctly, derivatives can work favourably for you. However, you must remember that just like any other type of investments, market risks will always be present.

What can be done to avoid derivative risks?

Risks will never be avoided, but good investors can lessen their risks and increase their rewards at the same time.

After the 2008 financial crisis, regulators around the world have focused on creating a safer environment for investors. If you are aware of ways risks are lessened, it will increase your opportunities in earning from derivative instruments. Knowledge on these things will help you avoid derivative risks.

The reduction of Bilateral Credit Risk

Bilateral Credit Risk is also called Counterparty Risk. It revolves around the possibility of one side of a trading counterparty going into default and failing to complete the swap payment.

Imagine being an online seller of collectibles. Since they’re unique, you have to make sure that you only get sure buyers. One day, you’re scheduled to meet a buyer. Since your profits for this trade is high, you were fine with delivering the item to an area near the buyer’s house, even if it will cost you gas. You arrive on time and contact your buyer. Suddenly, you realise, it’s already been an hour. And then two. You were ditched – this is bilateral credit risk. You didn’t get anything in your gas and time investment. Aside from that, you also lost the opportunity to sell the item to someone else.

In order to lessen the possibility of this happening, institutions require swaps to be cleared through a central counterparty. The role of a central counterparty – which is not a bank – is to stand between two sides of the trading system and guarantee the performance of the transaction.  This change puts the focus of possible risk on only one area, making it easier to adjust and fix in case of failure.

According to a speech by Governor Jerome Powell of the Federal Reserve Board, “Rather than trying to assess its exposure to all of its trading partners, a market participant would need to manage only its exposure to the central counterparty.”

In this manner, if one side of the trade fails to complete the transaction, the central counterparty steps in and completes the needed payment. This has been done by other markets – exchange-traded funds and options market monitored by clearing houses. These clearing houses make sure that all sides are able to meet their obligations.

 

The inclusion of Margin Requirements

The inclusion of margin means collateral can now cover potential losses.

This is how margin requirements work: if, for example, your swap value decreases, you will be required to add more money to ensure that there is a buffer for the capital. What does this do? If losses should occur, the players of a trade have the margin that can absorb the losses.

If, for example, you become interested in investing in gold through exchange-traded funds, you have to make sure that it involves margin requirements. These requirements will protect your account from depleting despite possible losses.

Before the 2008 financial crisis, global regulators did not create these ways to lessen the risks of derivatives. Risks cannot be avoided; it can only be lessened while making sure that your rewards are increased as well. With this knowledge, you can minimize derivative risks and make them work in your favour and advantage.

Now that you know that derivatives are safer with central counterparties and margin requirements, make sure you have these before entering derivative investments. There are still a lot of individuals and companies that directly sell derivatives without these conditions. You must avoid these companies to make sure that you only deploy your hard-earned money to safe environments.

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C.E.O @ The New Savvy
Anna Haotanto is passionate about finance, education, women empowerment and children’s issues. Anna has been featured in CNBC, Forbes, The Straits Times, Business Insider, INC and The Peak Singapore. She was nominated and selected for FORTUNE Most Powerful Women conference in 2016 (Asia) and 2015 (San Francisco, Next Gen). Anna has 10 years of experience in the financial sector and is currently a Director in Tera Capital. Her previous work experience includes positions at Citigroup, United Overseas Bank, a regional role in Business Monitor and a boutique private equity firm based in Shanghai. She graduated from Singapore Management University (Finance and Quantitative Finance).