The meaning of derivatives
You've probably seen derivatives mentioned pretty frequently in the financial news media. Even a cursory glance at the articles published daily here at the Fool will reveal many mentions of financial derivatives. We bandy about terms like put options, commodity futures, and interest rate swaps all the time!
But it's important to take a step back and grasp properly what all these terms mean.
Derivatives are often misunderstood because they seem so complex and esoteric. When would you ever need to buy a Bermudan call option? Many investors simply put them in the 'too hard basket'. We leave them to the professionals — like hedge funds and sophisticated day traders. Perhaps rightly so.
However, derivatives still play a major role in many financial systems. This means that having at least a working understanding of derivatives can help you greatly on your investing journey — even if you're just a novice!
This article will cut through all the financial jargon to tell you exactly what derivatives are and how you should approach them.
What's in a word?
Let's start by discussing why these financial instruments are called derivatives in the first place.
The one thing that links all these different types of financial products — from a currency swap to a put option — is that they all derive their value from an underlying asset, group of assets, or benchmark (like an interest rate).
The underlying assets are usually shares but can be anything from bonds to commodities (like wheat or gold), currencies, or even entire indexes.
How do derivatives work?
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.
Depending on how the price of the underlying asset changes, a derivative contract will result in different cash payouts for the parties to the contract. This means investors who use derivative contracts can either speculate on a potential price move or hedge against losses on their existing positions.
For example, suppose an investor wants to bet that Telstra Corporation Ltd (ASX: TLS) is about to report a stronger-than-anticipated earnings result. In that case, they could buy call options on Telstra stock, which would pay out if Telstra shares rise.
If, on the other hand, you were an existing Telstra shareholder and were fearful that the earnings result might be worse than expected, you could buy put options on Telstra shares, which pay out if the Telstra share price falls. This would offset the potential losses on the shares you already hold, hedging your risk.
And why do investors use them?
One of the key functions of derivative contracts is to manage and transfer risk. In the example above, you can see that if you bought call options, you would be speculating on the Telstra share price and taking on the risk that it would fall. However, if you bought the put options, you would be doing so to reduce your risk.
This illustrates how investors use derivatives to manage their risk levels. While derivative trading can be speculative and risky, it's important to remember that many corporations and financial institutions use derivatives to hedge or reduce their risk exposures.
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 & Investments Commission (ASIC) in the same way other investments like shares and bonds are regulated.
Let's take a closer look at some examples of derivative contracts.
Types of derivatives
Investors use two main types of derivative products: 'contingent claims' (like options) and 'forward claims' (like futures and swaps).
Options
Quite simply, an option contract gives an investor the 'option' (but not the obligation) to 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', which 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. A put option is the opposite and will enable you to sell a share at a certain price.
In our previous example using options on Telstra stock, the speculator could have bought call options expiring in one month with today's market price as the strike price. If Telstra releases a positive earnings result and, in a month's time, its share price has risen 10%, the speculator can exercise their call options, purchase shares at the old market price, and immediately sell them for a 10% gain (minus transaction costs).
The Telstra shareholder, who is hedging their risk, could buy put options expiring in one month, with today's market price as the strike price. If Telstra's results underwhelm and its share price drops 10% over the next month, the hedger can still sell their shares at the old price, neutralising any losses they would have suffered (although they would still have to pay the transaction costs).
Options aren't free, and purchasing one will attract a 'premium' — aptly named, considering many investors use options like an insurance policy to protect them against negative outcomes. However, it's important to remember that if an option isn't exercised by its expiration date, the investment expires worthless, and you lose the premium you paid for the contract.
Futures contracts
Another popular type of derivative is the futures contract. As implied by 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 in the future.
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 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.
Companies often use futures (and similar derivative contracts called forwards) to hedge against fluctuations in the prices of commodities (like oil) that are essential for their business operations. For example, airlines may use futures contracts to hedge against movements in the oil price to offset the financial impacts of having to pay higher fuel prices.
You will often hear that the 'ASX futures are down' over the weekend when big news (in this case, potentially negative) comes out before the markets are open. Here, investors are betting the index will fall when it opens and are buying futures accordingly.
Swap contracts
Another type of forward claim is a swap contract. In a swap, two parties will agree to swap cash flows for a certain period of time.
The most common type of swap is an interest rate swap. Companies commonly use this type of derivative contract to hedge their interest rate risk.
Let's say you're a company that's just taken out a $3 million loan with a variable (or floating) interest rate. You are concerned that interest rates will rise in the future — potentially increasing your loan repayments — and would like to lock in a fixed interest rate over the life of the loan.
You could enter into a swap with another party, whereby they pay you the floating rate (nullifying your interest rate payments), and you pay them a fixed rate in return. If you purchase this swap contract, you've transformed your variable rate loan into a fixed rate loan.
Should ASX investors include derivatives in their investing strategy?
While using derivatives can be a great way for large institutional investors to reduce their risk and enhance returns, it's not usually recommended for everyday investors to try to trade derivatives. That's because most derivatives involve a lot of speculation, which is inherently risky for investors.
Valuing derivatives can also be a very complex exercise and requires more resources than most everyday investors have at their disposal. This makes it even harder for regular investors to make money from derivatives trading.
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 decide to travel down this avenue, ensure you understand the full implications of your actions.
