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A derivative is a financial instrument that derives its value from an underlying asset, such as a stock or bond, or a benchmark, such as a market index. Derivatives can also represent statistics or numerical indexes not related to financial assets.

Derivative investments work as a contract between two parties, a buyer and seller. The derivative is a secondary security, meaning it is not an asset itself, but rather it tracks the value of an underlying asset. This puts it into the category of secondary securities. The value of a derivative is based on market events, price changes, and other factors related to the underlying asset.

Experienced investors often use derivative finance to hedge their investments against future loss or profit from upcoming market shifts, but some investors also use them to profit or speculate on commodities like gold or oil. They can serve different purposes for different people, such as limiting risk related to possible future events.

How Does a Derivative in Finance Work?

A derivative is a contract that includes information about rules and asset costs for a particular future transaction that may take place. For instance, if an investor has a significant amount of a particular stock with an unrealized gain, they might choose to enter into a derivative contract that gives them the ability to sell it at today’s prices on a future date. This will give them some protection against future losses.

Derivatives are also a way to give investors exposure to a certain asset class without having to actually buy the assets. The seller of a derivative doesn’t have to actually own the underlying asset. They can give the buyer money to buy the asset, or they can give the buyer another derivative contract of the same value of the first one.

Derivative Example

You might have a derivative that provides you with the right to purchase 50 shares of a particular stock for a set price of $1,000 per share in six month’s time. This will be a valuable contract if the stock is trading higher than $1,000 and continues to trade at that level in six months. But if the stock goes down in value and trades under $1,000 per share then the derivative won’t have any value.

3 Types of Derivatives

There are two categories of derivatives: lock and option. Lock contracts include swaps and futures. These form an obligation between the two parties. Option contracts give the parties the right, but not the obligation, to fulfill the contract transaction.

Options

One of the most common examples of a derivative is an options trade, which gives traders the right to buy or sell a stock at a specific price within a certain period of time. The options buyer will pay a “premium” is paid upfront, but when the contract expires the right to buy or sell is no longer valid.

If a call option is “in the money,” that means that the strike price is lower than the stock price, while a put option is “in the money” when the strike price is higher than the stock’s price. “Out-of-the money” options are the opposite, and “at the money” options have a value that’s roughly equal to their strike price.

The difference between options and futures is that options give traders the right to buy or sell but they are not obligated to do so. If the options contract doesn’t go the way the option buyer had hoped, they wouldn’t exercise their right and they would only lose the premium they paid upfront. There are many different options-trading strategies.

For example, some options traders use a straddle technique, which is a neutral options trading strategy creating the opportunity for an investor to profit whether the underlying asset goes up or down in price.

Investors may also sell naked options, in which they have not set aside the cash or underlying security to meet the obligation of the contract. If the option holder in that case decides to execute their option, the seller will need to buy the security or provide the cash that they now owe.

Recommended: Popular Options Trading Terminology to Know

Futures

With futures derivatives, the buyer and seller set a price for the future exchange of an asset or commodity. The contract includes the price, the amount, and the future settlement date. The contract obligates them to execute on the transaction.

Only a small amount of the total asset value is deposited into one’s account, but a higher amount must be kept in the account to cover losses that might occur. Once the contract is entered into, the price of the underlying asset is tracked daily, and any gains or losses are added to or removed from the trader’s account until the contract is sold or expires.

There are specific futures exchanges set up to monitor and standardize futures trading. But some similar contracts known as forwards are sold in over-the-counter markets that are unregulated and allow for more negotiation.

Swaps

Swaps are contracts traded over the counter for the exchange of financial terms or cash flows such as interest rates and currencies. Companies can swap types of interest rates in order to get better terms. Oftentimes one rate is variable and the other rate is fixed. With currency swaps, companies can invest overseas with a lower risk of exchange rate fluctuations.

How Derivative Trading Works

A derivatives contract says that one will either earn or pay money related to the underlying asset. Although there is an initial deposit for the derivative contract, there is the risk of having to pay more depending on how the asset’s value shifts during the period of the contract.

There is additional risk involved in trading derivatives because there is a possibility that the losing party won’t pay the money owed, and this can lead to legal trouble as well. If there is a contract related to an unregulated market this can also be risky because there is potential for market manipulation.

Once a derivative contract is entered into, the buyer can either hold onto it until the expiration date when they purchase the asset at the agreed upon price, or they can sell the contract to someone else, potentially for a profit. Trading one derivative for another one prior to the contract end date is common. Generally the contract will sell for only a tiny amount of the value of the underlying asset, but the value of the contract can fluctuate along with asset price fluctuations.

There is a small down payment involved for entering into the contract, known as “paying on margin.” It’s typical for derivatives for stocks and market indexes to represent groups of 100 shares. For example, there could be a contract to purchase 100 shares of a stock for $3,000 per share, and the contract might trade at $3 per share per contract.

Before entering into a derivative contract, it’s important to understand how derivatives work and read what the contract entails, including the disclosure statement. There will be an agreement to sign stating that both parties have read and understand the terms.

Also, trading derivatives requires ongoing work and attention. Markets can change quickly and there may be obligations throughout the contract period such as tracking the value of the underlying asset.

Costs

When entering into a derivative contract, there may be a deposit and an initial fee, and there may also be a holding fee involved as well as additional hidden fees. Pricing for derivatives vary depending on the type and value of the underlying asset as well as the broader market for that derivative.

Pros and Cons of Trading Derivatives

There are several pros and cons to trading derivatives. Some of the main ones are:

Pros

Derivatives traders enjoy several advantages by using the financial instrument. Those include:

•   A hedge against the risk of future losses

•   An opportunity for speculation

•   Exposure to an asset without having to purchase it

•   Can help predict future cash flows

•   Provides the ability to lock in prices

Cons

In addition to the advantages, there are several drawbacks that derivatives traders should understand.

•   Trading derivatives is very complex and can be risky for inexperienced traders

•   The derivative contract may not be liquid or easily sellable on the open market

•   There is a risk of losing more than you invest, if you’re using naked options

•   Online scams in derivatives trading are common, adding to the risk

•   There are fees and costs associated with the contract

•   There may be ongoing maintenance and time commitment required

Financial Derivatives Regulations

Regulations around derivatives depend on where they are traded. The Securities and Exchange Commission regulates derivatives traded on national securities exchanges, while over-the-counter derivatives may not have any regulating body.

In the latter case, the parties negotiate the terms of contracts on their own. Sometimes these parties include banks and financial institutions regulated by the SEC. Futures brokers and commercial traders must be registered with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC).

The Chicago Board Options Exchange (CBOE) is the most well known options exchange platform and is regulated by the SEC. These regulating bodies help to prevent fraud and abusive trading practices and keep the markets running fairly and smoothly.

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Derivatives can be a riskier type of investment but they can provide value to both institutional and retail investors’ portfolios when used wisely. Trading derivatives requires more work than simply buying and selling more traditional securities, but the additional risk and additional work can also yield greater rewards.

SoFi offers an intuitive and approachable options trading platform, thanks to its user-friendly design and the educational resources about options it provides. Investors can trade options from the mobile app or the web platform, depending on their preference.

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