If you’ve ever heard colleagues, friends or family members mention the word ‘derivatives’, they may have been led to believe that it is an easy way for them to earn some money on the side, or even as a tool for them to live off.
What they probably don’t know about derivatives is how they work, or the huge amount of complexity that follows this rather enigmatic, yet ubiquitous tool.
But what are derivatives?
According to most websites and definitions given by the various institutions, derivatives are contracts that derive their inherent value from an underlying entity, or entities, depending on what derivatives you’re looking at.
These derivatives can take the derivative the values of digital, non-physical assets like stocks, a stock index or interest rate. Usually, people buy contracts of derivatives to bet (to a certain extent) on the general direction of the underlying asset.
If you’re completely and utterly lost after reading the above, don’t worry. It really is confusing when you’re just starting out. Let’s break down the terms a little to further understand!
The first things to know are the prerequisite terms like contracts, options, futures and assets.
Contract: A contract, specifically a forward contract (or just a ‘forward’ in the realm of traders) is basically a non-standardised contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument.
Basically, it’s just like an agreement to buy or sell an asset in the future.
It can really be anything, from stocks to indexes. There are many derivative contracts in the market, which will be explained in a little bit!
Options: An option is a contract which gives the buyer a right, but not an obligation to buy or sell an underlying asset at a specific price (this price is known as the ‘strike price’ in the market) before or at a certain date.
It just means that if you buy an option, it means that you have the option to choose if you want to buy the asset at a certain price in the future.
This is usually useful for people who like to buy low and sell high and are capable of timing their entries well, or know that the performance of an asset will rise or fall, depending on the type of options
Futures: Okay, this is where things can get a little more complicated. A futures contract (or just ‘futures’ if you want) is a forward contract that can be traded between parties other than the initial two that initiated it.
These parties agree to buy or sell an asset (see below) for a price that they agree on today, with a payment and delivery coming in at a later date (i.e. delivery date)
A futures contract’s underlying asset is not an asset, but a derivative of an asset. Hence, futures are derivative products.
You know derivatives right? A derivative has an asset as an underlying entity. Let’s call this D1.
The futures contract derives the value of the derivative above D1, as its underlying entity.
It seems like a shell in a shell, to help your imagination. I know it took me a long time to understand this (because it was so weird!)
Swaps: This is the hardest to understand if you ask me, despite its relatively simple nature. A swap is a derivative where 2 counterparties exchange cash flows of one party’s financial instrument for those of the other financial instrument.
Basically, 2 parties can swap bonds, or other types of tradable assets with each other to gain certain benefits (usually more money. What else right?)
Swaps can generally go very deep and complex. However, let’s just stop here and use the simplified concept of a swap, to keep things simple for now.
Asset: Assets are the most straightforward to understand: an asset is something that produces a positive economic value. The most tangible form of this positive economic value would be in the form of money.
Now that we know some basic terminologies and ideas, the definition of a derivative now makes much more sense.
So based on the definitions above, a derivative just takes the value of its underlying asset, typically a stock of a company OR an index (a bunch of stock prices with an average running through them) and then derives a value from them.
These derivatives often take the form of options, futures, forwards contracts and swaps. Most commonly used derivatives are options on stocks, as these are readily available through your brokerage firm!
To get started with trading with derivatives, you should consult your local brokerage firms. However, not all firms are made equal; some will offer benefits that you can take advantage of, depending on the situation.
Of course, if you’re someone with deeper pockets, you could immediately go for the bigger brokerages. These usually offer better incentives and prices.
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