What is a Derivative?

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An introduction to derivatives

Talk of derivatives flies around the investing world with much vigour. But many investors don’t fully understand the ins and outs of what derivatives are, how they work and the role they play in the financial system. 

Because of this, investors tend to regard derivatives as belonging in the domain of professional or ‘advanced’ investors and traders. Perhaps rightly so. As such, today we’ll talk about derivatives and how an ordinary investor should approach them.

Let’s start by discussing why these instruments are called derivatives in the first place. Products are known as derivatives because they derive their value from another underlying asset or group of assets. These are usually shares, but can be anything from bonds to commodities, currencies or entire indexes.

How do derivatives work, and why do investors use them?

Most derivatives are contracts. These contracts are inked between two (or more ) parties and anchored to the price of an underlying asset, as described above. Typically, an investor enters into a derivative contract with an expectation (or fear) that the underlying asset’s price will fluctuate either to their advantage or disadvantage in the near future. 

As such, most derivative investors use these instruments to either ‘make a bet’ on an expectation that an asset’s price will rise or fall for the purpose of making a profit, or otherwise protect or hedge their positions or portfolio if a price movement does occur.

These contracts can be (although aren’t always) traded on the ASX share market or the over-the-counter (OTC) market in a similar manner to ordinary ASX shares. Their issuance and trade is also regulated by the Australian Securities and Investment Commission (ASIC) in the same way other investments like shares and bonds are regulated.

Let’s look at some derivative examples.

Types of Derivatives

There are two main types of derivative products that investors use: options and ‘lock contracts’. Of the latter, by far the most common types are ‘futures contracts’, which you may have heard of.

Options

Options are something many investors might have heard of or even received, and yet are not widely understood. Quite simply, an option contract gives an investor the ‘option’ to either buy or sell a particular asset (we’ll use shares as an example) at a certain price, at a certain date. This price is sometimes referred to as the ‘strike price’ and the date is known as the ‘expiration date’. 

As an example, a company might issue call options for their own stock to their own investors at today’s market price, which will expire in 2 years. In this way, the company is incentivising its investors to stick with the company for a future reward. 

Options aren’t free of course, and purchasing one will attract a ‘premium’ – aptly named because many investors use options as an insurance policy of sorts. If an option isn’t exercised by its expiration date, the investment becomes worthless. Additionally, an ASX company can ‘issue’ options to their existing investors as part of their shareholder remuneration strategy. 

There are two types of options you can purchase or be issued with: call options and put options. A call option is a buying option, allowing you to buy a share at a certain price, whereas a put option is the opposite and allows you to sell a share at a certain price.

If an investor decides a company, say Westpac Banking Corp (ASX: WBC), is overvalued at $17, they might purchase put options for Westpac shares that allow them to sell the shares at $17 in a year’s time. That way, if the investor is right and the shares go down to $15 over the next year, that investor can make a quick profit.

Futures contracts

Another popular type of derivative is the futures contract. Again implied in the name, a futures contract allows the investor to make a ‘bet’ on what the price of a share, commodity or other asset will be on a certain date. 

It is perhaps easiest to understand with a commodity example. If gold is today trading at US$2,000 an ounce, and an investor thinks it will be priced at US$3,000 by the end of next year, they can purchase a futures contract for gold at today’s price of US$2,000 for December 2021. 

That way, if gold is indeed going for US$3,000 an ounce by that date, the investor only needs to pay US$2,000 per ounce, saving themselves quite a bit of money. Of course, this can backfire if gold falls over the year in question. If this were to be the case, the investor would find themselves out of pocket. 

You will often hear that the ‘ASX futures are down’ over the weekend when big news (in this case, potentially negative) comes out and the markets aren’t open. What is happening here is that investors are assuming the index will fall when it eventually opens and are buying futures accordingly.

Should ASX investors use derivatives as part of an investing strategy?

While using derivatives can be a great way to reduce risk or enhance returns, derivatives are not as widely accepted as ASX shares for a reason. That’s because most derivatives involve pricing speculation, which is inherently dangerous and risky for investors. 

The market can price assets differently for a whole range of reasons. As the famous economist John Maynard Keynes said almost 100 years ago: “Markets can stay irrational longer than you can stay solvent.”

There is nothing wrong with staying out of derivatives entirely, and just concentrating on building a portfolio of quality ASX shares instead. But if you do decide to travel down this avenue, make sure you understand the full implications of what you’re doing.

Last updated 22nd July, 2021. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.