What Are Derivatives, And How To Invest

What are derivatives? In short, they’re complex financial instruments that investors should think carefully about before buying.
Sam Taube
By Sam Taube 
Published
Edited by Pamela de la Fuente

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If you were reading financial news during the Great Recession — or if you've seen "The Big Short" — you might have heard of derivatives before, and probably in a negative light. These complex securities played a significant role in the 2008 wave of bank failures that brought down Lehman Brothers and Bear Stearns.

Derivatives can be very risky investments, and they generally aren't suitable for investment novices. But they're not all bad. Derivatives play a variety of important roles in our financial system — and there's a chance you indirectly own some without even knowing it.

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What are derivatives?

"A derivative is like a side bet on something else. It's a contract that lets two parties agree on a price for something that will happen in the future, like the price of a stock or commodity," Angela Moore, an Orlando, Florida-based certified financial planner and the founder of Modern Money Education, said in an email interview.

Henry Hoang, an Irvine, California-based certified financial planner and the founder of Bright Wealth Advisors, says that a derivative is termed a derivative because "it's a contract that derives its value from an underlying asset."

Types of derivatives

Moore said that options and futures are both types of derivatives.

"Options contracts are contracts between two parties that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific time frame," Moore said.

Options are often used to speculate on stocks or to protect a stock investment against a downturn, or as an alternative to short selling.

"Futures contracts, on the other hand, are agreements between two parties to buy or sell an underlying asset at a specific price and date in the future. Futures contracts are often used by commodity producers and consumers to lock in prices for their goods or to hedge against potential price fluctuations," she said.

"Other types of derivatives include swaps, which are agreements between two parties to exchange cash flows based on different financial instruments, and forwards, which are similar to futures contracts but are traded over-the-counter (OTC) rather than on an exchange," Moore said.

Hoang says that there are also futures contracts that use stock indexes such as the S&P 500 as their underlying asset and currency derivatives whose value is derived from the exchange rate between two currencies.

"That's another way to either speculate — or have some protection — in terms of fluctuating currency values around the world," Hoang says.

Leveraged ETFs also use derivatives, such as swaps and futures contracts, to attempt to deliver some multiple of the daily performance of an underlying stock index — although they're not necessarily a good substitute for index funds.

"For example, a leveraged ETF might aim to deliver twice the daily return of the S&P 500 index. These types of ETFs are often used by traders looking to make short-term bets on the market, but they can be highly risky and may not be suitable for long-term investors," Moore said.

» Need to back up a bit? Learn what options trading is

Pros and cons of derivatives

Derivatives got a bad rep from the 2008 financial crisis — but like any investment, they have a distinct set of upsides and downsides.

Pros of derivatives

Hoang says that derivatives generally have a lower purchase price than the underlying assets they control. Options contracts, for example, are usually cheaper than the stock shares they represent. That can make them useful for stock bets that would be prohibitively expensive otherwise.

"You're going to be able to purchase the option at a fraction of the cost, and that'll give you some leverage. If your bet is right, you're able to make a significantly higher return, because your outlay is significantly less than it would have been if you went out and purchased that asset outright," Hoang says.

Moore said that derivatives also can be used to manage risk and protect against potential losses.

"Derivatives can be used to gain exposure to markets that might otherwise be difficult or expensive to access. For example, if you want to invest in gold but don't want to buy physical gold, you could buy a futures contract or an ETF that tracks the price of gold," Moore said.

Cons of derivatives

Some derivatives provide less-risky ways to speculate on stocks or other assets — but others may be much more risky than simply trading the underlying asset.

Hoang says that selling an option at its origin — also known as writing an option — is one type of trade investors should approach cautiously.

"The person who is selling the contract needs to be very careful because if it's exercised, contractually, you're obligated to deliver," Hoang says.

If you write a "naked" option — an option on a stock you don't own — you could end up in a position where the underlying stock does the opposite of what you want it to do, and then the option buyer exercises the contract.

That would force you to buy the underlying shares at the market price and then immediately sell them to the option buyer at a lower price in the case of a bad call option sale. In the case of a bad put option sale, it would force you to buy the underlying shares at an above-market price.

» Learn more about selling options: Covered calls and selling puts

If you're buying and reselling options or other derivatives, you don't have the same risk of being forced to purchase the underlying asset at an unfavorable price. But Hoang says those trades aren't risk-free, either.

An option contract often costs less than the shares it controls — but if you make a bad option trade, you may lose the entire amount you paid for the contract. And if you make a lot of bad options trades, that can create a real drag on your overall returns.

"The losses can really add up over time," Hoang says.

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How to buy derivatives

You'll need a brokerage account to buy derivatives — and you may need to shop around a bit to find a brokerage that offers the kinds of derivatives you're interested in.

The availability of options, futures, swaps, forwards and currency derivatives varies from broker to broker.

» More: See our roundup of the best options trading brokers

Moore said that investors should expect their brokerage to put up some restrictions around derivatives trading — and that newcomers to derivatives trading should consider consulting a financial advisor.

"Many large brokerage firms have minimum asset and/or net worth requirements to be eligible to gain access to alternative investments such as derivatives," she said.

"If you're new to derivatives, it may be a good idea to work with a financial professional who has experience with these types of investments. A professional can help you understand the risks and benefits of derivatives and can help you develop a strategy that fits your investment goals and risk tolerance," Moore said.

Hoang suggests practicing derivatives trading with simulated money — using paper trading software, for example — before starting. He says investors should "start very small and grow slowly" when they're ready to buy derivatives. » Ready to get started: See our list of the best financial advisors

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