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 their role in the financial system. 

Because of this, investors tend to regard derivatives as the domain of professional or ‘advanced’ investors and traders. Perhaps rightly so. 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 between two or more parties anchored to the price of an underlying asset. Typically, an investor enters into a derivative agreement 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 to make 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, similarly 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

Investors use two main types of derivative products: ‘options’ and ‘lock contracts’. The most common lock contracts are ‘futures contracts’. 

Options

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 specific price on a certain date. This price is sometimes referred to as the ‘strike price’, and the date is known as the ‘expiration date’. 

There are two types of options: 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 will enable you to sell a share at a certain price.

As an example, a company might issue call options for its stock to its own investors at today’s market price, expiring in two years. In this way, the company incentivises its investors to stick with it for a future reward. 

Options aren’t free, 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. 

As another example, if an investor decides 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. That way, if the investor is right and the shares go down to $15 over the next year, that investor can make a 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 the price of a share, commodity, or other assets on a specific date. 

It is perhaps easiest to understand with a commodity example. If gold is trading at US$2,000 an ounce today, 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 2023. 

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. If this were 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 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 21 April 2022. 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 recommended Westpac Banking Corporation. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.