Derivatives are financial securities whose value comes from an underlying financial asset, asset class, index, or other investment. The availability and value of a derivative can be based on the performance of the underlying asset, interest rates, currency exchange rates, commodity prices, bond and stock prices, and various market domestic and foreign indexes.
Derivatives can be used to hedge risk or speculate on the price of an underlying asset. Hedge means to offset investment risk and can be done by eliminating the possibility of gain or loss on an underlying. Common derivatives include options, futures contracts (and forwards), and swaps. Common underlying assets for derivatives include stocks, bonds, commodities, currencies, interest rates, and market indexes.
Derivatives
Options are agreements to buy or sell property in exchange for an agreed upon price. The right can be exercised or does not have to be exercised. A call option gives a buyer the right to buy an underlying asset at a fixed price on or before a specific date. A put option gives a buyer the right to sell a specified number of the underlying asset at a particular price within a specified time period. For example, if one owns shares of ABC stock a call option can be purchased to take advantage of an increase in the stock price and a put option can be purchased to take advantage of decreases in the stock price. Options can be used to take advantage of increases and decreases in stock prices without buying or selling shares based on (un)expected changes in stock prices. The primary difference between options and futures is that the option does not have to be exercised whereas futures are an obligation.
Futures contracts are agreements between a buyer and seller to purchase or deliver a specific amount of a commodity, currency, or financial instrument at a particular price on a specific date in the future. These contracts obligates the buyer to purchase the underlying commodity and the seller to sell the underlying commodity according to the terms of the contract. Futures contracts can be settled by delivering the underlying asset or by an accounting entry for the gain or loss on the contract. For example, a trader speculates that crude oil will rise from its current price of $42 within the next 30 days because of spring break. Therefore, on March 2 the trader purchases a futures contract for crude oil at a price of $42 per barrel that expires on April 2; the seller on the other side of the trade is obligated to deliver oil for $42. If crude oil rises to $52 a barrel the buyer of the futures contract can accept delivery or can sell the contract before expiration and keep the profits.
Swaps are typically used to exchange one kind of cash flow with another. Common types of swaps include interest rate and currency. A trader or investor with a variable rate security can obtain a fixed rate by entering into an interest rate swap; or a trader with fixed rate security would switch to a variable rate by also entering into an interest rate swap. A currency swap can be used to exchange currency exchange rate risk, default risk, and cash flow risk between business assets and activities.
Underlings
Stocks are a type of security that gives stockholders a share of ownership in a company. Stocks are purchased as investments because of the potential to make a profit if stock price rises above what was originally paid; to receive dividends from distributions of a company’s earnings made to stockholders; and because of the ability to vote and influence decisions made by a company. Companies issue stock for different reasons including to expand or launch products or services; enter into new markets or regions; and pay off debt or finance capital improvements of current facilities.
Bonds are a debt security that pay interest based on a fixed or variable interest rate in addition to principal payments on predetermined dates. Bonds are issued by the Federal government, state and local governments, and corporations. Bonds can be purchased as a means to provide a predictable stream of income over a period of time.
Commodities are basic goods that can be used as part of an investment portfolio. Commodities can be bought and sold using futures contracts. Common commodities include bulk goods such as grains, metals, foods, and energy – grains include corn, oats, soybeans, and wheat; metals include gold, silver, platinum, copper, iron, and ore; foods include cattle and pork bellies; and energy includes heating oil, natural gas, and crude oil.
Currency that can be bought and sold using futures contracts include U.S. dollar, British pound, Euros, German marks, Swiss francs, Japanese yen. Corporations that buy and sell products around the world can hedge their currency risk using Currency Futures contracts. Currency risk is the risk that changes in the exchange rate during the time it takes to settle the futures contract will adversely affect the profit.
Interest rates
Indexes
Trading Derivatives
Sellers and buyers of futures contracts can sell their contract to a trader in which case the one selling would no longer be obligated to perform that part of the contract, instead the trader steps in and is obligated to perform in place of the person from whom the contract was acquired. Sell and purchase of options are done …… Sell and purchase of futures contracts are done through the Futures Market Exchange.
In addition to risk associated with derivatives, transaction costs and taxes should be considered in evaluating whether to do a particular strategy and value each investment. Transaction costs are costs charged to buy and sell an investment or trading strategy. Transaction costs include commissions paid to brokers, market maker spreads, and direct taxes. Keeping track on purchases, sells, gains, losses, and transaction costs/fees will help understand and simplify reporting and paying taxes associated with derivatives.
A brokerage account is required in order to trade on the Exchange. Education should be done about how the Exchange works should be done before setting up an account and trading because there are a lot of rules, policies, procedure, and nuances that are particular to the different types of futures contracts and trading exchanges.