There is no reason to avoid derivatives when it comes to investing or trading, even if you consider yourself a beginner in this field. Yes, it’s true that derivatives have controversial reputation due to the increased risk and the difficulty to predict the price movements. But we assure you, traders avoid this efficient investment vehicle solely due to lack of proper knowledge about derivatives’ nature, “dangerous” behavior, pros, and cons.
Let’s start with the definition of derivatives. A derivative is a form of security with the specific underlying asset. Therefore, the price of this derivative depends directly on the price of its underlying asset: options, future contracts and any other assets traded on the market.
Trading and investing in derivatives are not always risky but it takes a perfect understanding of its mechanism. Derivatives are the “shadows” of their underlying assets and they reflect the behavior of assets to the certain extent, but experienced investors always keep in mind that derivatives are the separate investment vehicle with own demand and supply and the price swings.
Here is the striking fact: the most popular derivative is money! Because money itself is not a value, it reflects a value of the country’s reserves (when it comes to the USA and dollars).
Understanding the price behavior
Let’s consider the price behavior, taking as an example the most common types of derivatives – future contracts (in short they are widely called futures) and options. Futures are the contracts (the Agreement between two parties: buyer and seller) where the buyer pays now for the commodity that will be delivered by the seller in future.
Options (put and call options) are the derivative that represents the underlying asset. It’s the contract between seller and buyer whether the one party has the right (not the obligation like with futures) to buy the underlying asset on certain terms.
For example, if the underlying asset of the coffee beans futures drops or rises in price, it’s reasonable to expect the same behavior from its derivative.
But it turns out that derivative’s price often doesn’t follow its underlying asset and instead it is affected by several other factors:
- The actual price of assets the derivative represents.
- The time till expiration (for options) or a time to the asset’s delivery (for future contracts).
- Volatility and other factors.
Most common types of derivatives investors prefer
Basically, every vehicle which price is derived from the price of its underlying asset is the derivative and there are dozens of types. Here are the four most common kinds of derivatives widely traded on the market.
1. Future contracts
Gold, oil, beef, cocoa and other future contracts are traded in enormous volume every day on the world’s exchanges. The seller of the future contract is obliged to deliver the commodity to the buyer by a certain date (determined by the future contract itself). Sometimes producers of commodities or sellers of futures fail to deliver the products and that influences the price of future contracts, while the price of that particular commodity is not affected whatsoever.
2. Forward contracts
Derivatives in the form of Forward contracts have appeared the first on the market. On its concept the forward contract almost identical to a future contract with the one essential difference. Unlike future contracts that are traded with mainly speculative purposes, forward contracts are bought in order to get the commodity delivered to a buyer. Thus, a forward contract could be considered a form of Insurance, where both parties deal with the real commodity in the future by the price they have agreed on at present moment.
The concept of options differs from future contracts. Options are the contracts where the party obtains the right (not the obligation) to buy or sell this derivative (means the option) at the defined and fixed price in a frame of the certain period of time. The trader or investor buys this right in hopes that during the certain time the price will go an expected direction, bringing the profit to an investor.
Swap is a very interesting and popular derivative. It is basically two contracts, according to which two parties agree to exchange certain types of financial instruments. The second contract implies the counter deal with the same instruments that will be bought or sold after the agreed period of time on certain terms. Terms of the counter contract differ from the terms of the first contract, but financial vehicles remain the same.
Swaps are very popular among corporate investors as it gives them a great tool for shifting certain assets (in risk-management purposes) without the need to change the owner of assets and instruments.
Pros and Cons of investing in derivatives
- Derivatives are great if you don’t want (for some reasons) to deal with financial instruments that are traded on the spot market (spot – is a current price market).
- Derivatives are easy to approach and invest into even without the mediation of a broker.
- Derivatives are various in types so you may choose from hundreds of vehicles and deal with those you understand the most.
- Derivatives are literally designed for a speculative trading, without involving real commodities, real stocks or other instruments. Besides, you may start investing in derivatives, having even a small amount of money, while trading with spot market vehicles often requires significant funds.
- Dealing with derivatives may imply an increased risk due to the sometimes unpredictable behavior of derivatives’ price.
- Derivatives often cannot be considered as a part of the long-term investment portfolio as it is hard to analyze them and therefore including derivatives in a certain strategy could be challenging (they can behave both as high-risk vehicles or as low-risk and low-yield ones).
- Some types of derivatives (for instances index-based funds) can perform under the market manipulations from the side of big players – corporations, mutual funds, that create panic on the market and hectic price movements.
TOP Brokers in the USA that offer derivatives
This is one of the biggest world’s brokers, offering trading futures and other derivatives on very favorable terms. You may open an account starting with $5.000 and pay only 35$ of the annual fee.
The whole variety of securities and derivatives are offered: bonds, stocks, Exchange-traded funds, mutual funds (with minor fees), future contracts and options.
The biggest advantage of this broker is extremely low commissions – $0.59 per contract. You are offered more than 50 types of future contracts (and options for futures) to trade with the margin 25% (for day trading).
The con of Generic Trade – the investor is limited by futures only and no other types of derivatives like many other brokers offer.
This broker requires $1.500 of the minimum amount for opening an account, offering more than 60 types of derivatives for day trading and investing.
It has great customer support as a good side but quite a high fee per contract ($2.25) as a negative side. On the bright side, Ameritrade does not charge any commission for account maintenance.