What are derivatives?

Derivatives are a type of instrument which can be used by traders to speculate or hedge positions. In this article, we discuss what a derivative is and some of the common examples of this instrument.

Definition of a Derivative

Derivatives are instruments where their value is derived from an underlying security. This means the price of the derivatives is dependent on how the underlying asset (being stock, bond, commodities, interest rate) is performing.

Types of Derivatives

Options

There are two types of options, a call and a put. A call option contract is a right to buy a stock and a put option contract is a right to sell the stock. In an options contract, there are two parties where there is an agreement to buy or sell at a pre-determined future price of an underlying asset before an agreed date. The buyer has the option but not the obligation to buy or sell the underlying asset on or before the agreed expiry date. However, the seller of the option (writer) has an obligation to buy or sell the agreed underlying assets.

Futures

Futures are similar to options except there is an obligation for both parties to transact. Two parties agree at a future date to buy and sell an underlying asset at a certain price. Futures traders can lock in a price for the underlying asset at a future date. These instruments are also standardized and hence there is an intermediary exchange involved. This is unlike OTC (over the counter) instruments where there just a contract between two counterparties.

CFD

CFD (contract for difference) is a contract between two parties which is usually between the investor and a CFD broker. The investor does not need to own the underlying asset, the investor makes money from the difference of the price of underlying asset at the start of contract and the price of the end of the contract. For example, in a long position, if the entry price of the trade is lower than the closing price of the trade then the seller will need to pay for the buyer the difference. If the closing price is lower than the entry price, then the buyer will need to pay the seller the difference. Traders can also take short positions if they anticipate the underlying asset will fall.

Swaps

Swaps are OTC (over the counter) instruments where the contracts are customized between two parties. There are no intermediaries involved and therefore there is a level of counterparty risk. The two parties involved in the swap exchange the cash flows they receive from financial instruments. Usually one party will pay out fixed payments and the other counterparty will pay floating payments. The two counterparties will agree on the terms of the swap such as the frequency of the payments and the start and the end dates.

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Why derivatives are used?

Derivatives are used to hedge positions and also for traders to speculate. Traders can use derivatives to make money in a falling market. As noted in some of the derivatives above, the trader does not need to own the underlying asset so they can short the market without having to borrow the underlying assets.

Lauren Hua is a private client adviser at Fairmont Equities.

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