Investing in derivatives may be a daunting prospect for the novice investor, but for the empresario with a little more experience and a positive approach, they can be an intriguing prospect.
What Is a Financial Derivative?
To use an analogy from the “physical” world of trading goods and services – a typical derivative of a product would be, perhaps, off road tyres being derivative of “standard” tyres. They’re still tyres – and cannot be described or sold as anything else without losing their value or the market’s trust. In the financial world, derivatives are stocks or bonds which have value in their own right, but that include a contractual feature that creates an added benefit but which cannot exist independently of the primary security.
While there are many variations, the three most common types of financial derivative that most financial strategies revolve around are options, futures and swaps.
Derivative options are contracts between two parties to buy or sell security on stock, or other investments. Purchase of the right to buy an asset at a set price, within a given timeframe is a ‘call option’. Conversely, the right to sell under the same conditions, is a ‘put option’.
Futures are the purchased right to buy or sell a commodity. They can be used to purchase financial securities.
A swap contract, allows two parties to exchange preferred features of their securities, such as a fixed interest rate for a varying interest rate.
Investors can purchase a financial derivatives on the open market safe in the knowledge that what they are buying is at their disposal should an opportunity arise. Usage of derivative features is not usually mandatory (with some exceptions, such as swaps), which makes derivatives a popular feature of sound investment strategy – this is known as financial engineering. With derivatives, it is possible to see a profit in a very short space of time, while a return on the primary investment may take years.
Derivatives are changeable; being bought and sold at a fast pace and with new terms being negotiated frequently, which makes them a high-risk investment and the likelihood of one party defaulting on their investment and long-tail changes in terms and conditions by subsequent owners. This makes financial derivatives a complex investment to manage and an unsafe option for a beginner. With a healthy expendable budget and an unrelenting attention span, however, the world of financial engineering could offer fantastic rewards and an interesting journey.