Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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 are considered leveraged products because, for a minimal investment, the investor can control a much larger position.
Derivatives 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. The value of a derivative is based on market events, price changes, and other factors related to the underlying asset.
Experienced investors often use derivatives to place bigger bets, to help hedge their investments against future loss, or to profit from upcoming market shifts. Some investors also use them to profit or speculate on commodities, such as gold or oil. They can serve different purposes for different people, such as limiting risk related to possible future events.
Key Points
• Derivatives are financial contracts that derive value from underlying assets such as stocks, bonds, or commodities.
• Derivatives are considered leveraged products.
• Options, futures, and swaps are common types of derivatives, each with unique features and purposes.
• Derivatives are used for hedging to manage risk and for speculation to profit from market movements.
• Trading derivatives involves significant risks, including potential for large losses.
• Potential advantages of derivatives include leverage, flexibility, and the ability to hedge against market volatility.
How Does a Derivative in Finance Work?
A derivative is a legally binding contract that can apply to various asset classes, including futures, swaps, and options trading. It outlines the terms, rules, and costs for a potential future transaction based on the performance of an underlying asset.
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 may provide them with 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. Derivatives are leveraged contracts, in that the investor pays a smaller fee to control the underlying position.
The seller of a derivative doesn’t have to actually own the underlying asset, and in many cases the buyer never owns the asset directly either. Derivatives provide exposure to the asset’s value rather than trading it directly.
Derivative Example
A derivative contract, such as a call option, grants the options buyer the right, but not the obligation, to purchase shares of a particular stock at a predetermined price of $1,000 per share (the strike price) within a six-month period (the expiration). The standard options contract is for 100 shares.
The appeal of this strategy, and the appeal of derivatives in general, is that the buyer is able to purchase the right to buy the underlying asset, at the strike price, on or before the expiration — and only pay the cost of the contract, which is the premium. In other words, options (like other types of derivatives) enable investors to make bigger trades than they could with just cash.
Types of Derivatives
There are two categories of derivatives: obligation-based contracts and option-based contracts. Obligation-based contracts include swaps and futures. These form an obligation between both parties to fulfill the terms of the agreement.
Option contracts give the parties the right, but not necessarily the obligation, to fulfill the contract transaction.
Options
Options are a common type of derivative that give traders the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a set time frame. Since the value of an option contract depends on the price movements of the underlying asset, it’s considered a derivative.
Traders use options for speculation or to hedge against potential losses, but they carry risks, including the possibility of losing the premium paid upfront (for buyers), and the potential for significant losses, particularly for uncovered (naked) option sellers.
Recommended: Popular Options Trading Terminology to Know
Futures
With futures contracts, 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 both parties to fulfill the contract.
Traders are required to deposit margin funds, which is a fraction of the contract value. They may also need to post additional funds, known as maintenance margin, to cover potential losses.
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. Futures contracts are traded on regulated exchanges, while similar contracts, known as forwards, are sold over the counter (OTC), allowing for more negotiation but less regulatory oversight.
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. Often, 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.
What Is Margin?
Margin requirements for derivatives trading differ somewhat from standard margin trading in stocks. In futures trading, traders must deposit an initial margin, which is a fraction of the total contract value, to open a position. They may also need to post maintenance margin to cover potential losses if the trade moves against them.
In options trading, margin requirements depend on whether an investor is buying or selling an option. Buyers pay a premium upfront, while sellers (writers) may need to post margin to ensure they can fulfill their obligations if the option is exercised.
Swaps may also involve margin requirements, particularly in over-the-counter markets, to mitigate counterparty risk. The specifics vary based on the contract terms and the regulatory environment.
How Derivative Trading Works
A derivatives contract says that the investor will either earn or pay money related to the underlying asset. Although there is an initial cost for the derivative contract, traders may be required to contribute additional maintenance margin if the underlying asset moves against their position.
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 the underlying asset price fluctuations — and as the expiration date draws closer.
There is a small initial deposit required to enter into the contract. This amount varies depending on the type of derivative and market conditions. For example, there could be a contract to purchase 100 shares of a stock for $3,000 per share, and the option contract might trade at a premium of $3 per share.
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.
Trading derivatives also 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
Derivative contracts come with various costs depending on the type of contract and the market where they are traded. Common costs include:
• Options: Premiums, commissions, and potential assignment fees
• Futures: Initial margin, maintenance margin, and exchange fees
• Swaps and Other OTC Derivatives: Transaction fees and counterparty costs
Derivatives are best suited for experienced investors who understand the potential risk of loss involved. Consider consulting with a financial professional to understand the full costs for specific trades.
💡 Quick Tip: When people talk about investment risk, they mean the risk of losing money. Some investments are higher risk, some are lower. Be sure to bear this in mind when investing online.
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, including:
• 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
• 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 vary depending on where they are traded. The Securities and Exchange Commission regulates derivatives traded on registered national securities exchanges, while over-the-counter (OTC) derivatives are typically subject to less oversight and may involve bilateral agreements between parties.
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 promote fair, orderly markets.
The Takeaway
Derivatives can be a riskier type of investment but they can provide value to both institutional and retail investors’ portfolios when used appropriately, and with a clear understanding of the risks involved. 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.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
*Borrow at 11%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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