What are Derivatives and Should You Invest in Them?
If you follow market news or have an interest in investing, you may have heard of derivatives and have an interest in learning more or even in trading them.
Derivatives are complex securities that derive their value from how other securities perform. Hence, their name: derivatives.
Derivatives can be useful for highly advanced investors who want to execute complex trading strategies.
However, derivatives can also be highly risky.
With derivatives, it’s easy to lose far more than the amount you invested, leaving yourself in debt to your brokerage.
We'll cover derivatives, how they work, how to trade them, and whether investing in them is a good idea.
How Financial Derivatives Work
There are many different types of financial derivatives. They are called derivatives because they derive their value from other securities.
Stocks, for example, have value because the ownership in the company they represent is worth something.
This is a common theme among derivatives.
Their value and changes in their value are dependent on the value of other securities.
Options are among the most common and simplest to understand derivatives. They give you the right, but not the obligation, to buy or sell a certain stock at a certain price.
For example, if you own a put option for company XYZ at $25 with an expiration date of December 31st, you have the right to sell 100 shares of XYZ for $25 each at any time up to the expiration date. Even if XYZ’s shares are trading at $20 on the open market, you can sell them at $25 because you own the option.
If you owned a call option instead, you’d have the right, but not the obligation, to buy the shares for $25 each.
Look:
There are many types of derivatives.
Options are just one example.
For example, futures let companies secure a price for a commodity, like oil or wheat, far ahead of the time they plan to make a purchase.
Each derivative can play a role in a company’s or individual’s investment strategy.
How to Trade Derivatives
If you’re interested in trading derivatives, the first thing you’ll need is a brokerage account.
Many brokerages let their customers trade derivatives, but not all brokerages are made equal.
Consider the costs
Some will charge high commissions for customers who want to do things like trade options while others charge no fees at all.
If you plan to trade derivatives frequently, look for a brokerage that will let you do it on the cheap.
For the more advanced investors
Because derivatives are risky, most companies will also want to make sure you know what you’re doing before you start.
You may have to meet account minimums or fill out some paperwork to explain your experience with derivatives before you can start.
For example, Vanguard, a popular brokerage, has four account levels that it assigns to customers based on their experience with derivatives. The account level you’re assigned determines the types of options you can trade.
Once your account is open and you’ve funded it, you can start trading derivatives.
This works very similarly to trading other securities, like stocks and ETFs. You can place buy and sell orders for the contracts you want to trade and let the broker fulfill them.
Derivatives as Part of an Investment Strategy
Derivatives can play a few different roles in your investing strategy.
Leverage
One of the most popular reasons to use derivatives is that they can provide leverage in your portfolio.
They make it easy to control larger stakes in a stock or ETF with a smaller amount of money.
Consider this example:
On the morning of October 22nd, 2020, one share of Apple was worth about $117. You could purchase a call option to buy 100 shares of Apple stock at $117 for $385.
If you bought three shares of Apple (at a total cost of $351) and the price increased to $130, you’d earn a profit of $13. If you purchased the option and the price per share increased to $130, you could exercise the option to buy shares at $117 and immediately sell them for a profit of $915 instead.
For a bit more than triple the price of a single share, you can control 100 shares in the company. This lets investors with small portfolios amplify their gains.
Now:
The risk is that this leverage also amplifies losses.
If prices fall, or even hold steady, it wouldn’t make sense for you to exercise the option.
Instead, you would let it expire, meaning you paid the $385 to buy the option and got nothing back.
Hedging
Another reason that derivatives, like options, are popular is that they’re a good way to hedge your bets or limit your losses.
Imagine you buy 100 shares in company XYZ at $10 each. You think the company is going to gain value, but you want to reduce your risk anyway.
You can buy a put option with a strike price of $9, which gives you the right to sell the shares for $9 each, even if their market value is lower than $9.
You’ll pay a small fee to buy the option, but as long as the option remains valid, your losses are limited to $1 per share, plus the fee you paid to buy the option. If you paid $25 to buy the option, you can’t lose more than $125 on the investment.
This strategy can let investors make riskier purchases without having to worry about completely wiping out their portfolio.
Should You Invest in Financial Derivatives?
Financial derivatives can be tempting for investors.
They offer the potential for huge gains, even with small amounts of money to invest.
The truth is:
Investing in financial derivatives is generally a bad idea for all but the most experienced investors.
Derivatives are complicated and can be difficult to understand, even if you think you know how they work.
Beyond that, the same leverage effects that give them the potential for huge gains also gives them the potential for huge losses.
With certain types of derivatives, you could lose far more money than you invested, leaving you in debt to your brokerage.
Most investors will be better served by a more traditional investing strategy. Buying shares in diversified mutual funds and ETFs can help you get exposure to the market as a whole at a relatively low cost.
If you do want some exposure to derivatives there are some funds that use derivatives as part of their investing strategy.
One popular strategy is for an income-focused mutual fund to write covered calls against stocks it owns as a way to increase the amount of income it produces.
If you’re looking for exposure to derivatives, this is one of the safer ways to get that exposure.
Conclusion
Derivatives are flashy and exciting because of the huge swings in value that they experience.
However, derivatives are also highly risky and are best left to highly advanced investors who are using them in complex trading strategies.
Everyday investors should avoid derivatives for the most part.
Instead, they should focus on building diversified portfolios using low-cost mutual funds and ETFs. These portfolios are more likely to produce a reasonable, positive return over the long-term.
