Derivatives are financial instruments that hold a value based on another asset. If that sounds complicated, don’t worry; I will explain it in more detail later. The most common derivatives are options, futures, and
swaps. Each has its pros and cons, but they all share the same general principle: they allow investors to take advantage of market fluctuations without buying and selling the underlying asset directly. So if you want to make money as an investor but don’t want to deal directly with risky investments like stocks or bonds, you can use derivatives as a strategic tool for managing risk and making profits simultaneously. Let’s see what these derivatives are and how you can use them for your benefit.
What exactly is a Derivative?
A derivative is a financial contract between two or more parties based on a specified underlying asset, such as equity, debt, or commodities like gold or silver. There are many different types of derivatives, but they all have just one thing in common: their value is determined by the underlying asset’s price. There are several different uses for derivatives. Some are used for speculation, while others are used to hedge against risk. You can think of derivatives as a sort of bet between two parties: one party is betting that the underlying asset’s price will go up, and the other is betting that it will go down.
Options
Options are one of the most common types of derivatives. They are contracts between two parties: an option seller (also known as the writer) and an option buyer. There are two parts of options: call and put options. A call option allows the buyer to purchase an underlying asset at a set price. And a put option allows the buyer to sell an underlying asset near or at a set price. Let’s look at this example here. Let’s say you hold a stock that you believe will increase in value over the next two months. You could buy the stock and hold on to it, but what if the price drops? What if you can’t afford to wait two months to see if your prediction comes true? Instead, you can buy a call option: which is a contract that gives you the option to purchase the stock at a certain price (the strike price) over two months. This would protect you in case the stock price dropped.
Firms That Use Options
Let’s look at some companies that use options: Airlines must predict how many passengers they will have in the short and long term. So they use options to protect themselves from unexpected changes in demand — for example, bad weather during the winter season that might reduce travel demand. Sales teams: Imagine a sales team has to sell a certain number of products every month. If they discover that they are behind their target but still have enough time left in the month to catch up, they can use options to buy themselves more time. Third, manufacturers: When a manufacturer must buy a raw material that is expensive and has a long lead time, they can use options to protect themselves from an increase in the price of that raw material.
Futures
Futures are another type of derivative that is similar to an option. A futures contract is a solid agreement between two parties or individuals to buy or sell an asset (usually commodities like grains, metals, or energy) at a specific time in the future at a set price. Investors or companies with a great deal of money most commonly use futures. For example, let’s say that a farmer harvests large crops of soybeans and wants to sell them before they spoil: the farmer could enter into a futures contract and promise to sell the soybeans at a set price in the future. This would assure the farmer that someone will purchase the soybeans from them even if the price of soybeans drops in the meantime.
Swaps
A swap is a contract agreement between two parties to exchange an interest rate or payment based on an underlying asset or financial index. The most commonly used swap is an interest rate swap, where two parties exchange a set amount of interest payments based on a specified underlying rate, like the federal funds rate or LIBOR (London Interbank Offered Rate). One party pays a floating rate, which changes with the rate on the underlying financial index, and the other pays a fixed rate that is agreed upon at the beginning of the swap.
Summing it all up
Derivatives are instruments that gain their value from something else. This can be an asset (like gold or shares of stock), an index (like the S&P 500), a trend (like volatility), or even a weather pattern. Derivatives have many different uses. They are mainly used to hedge against risk, speculate on price changes, or manage a portfolio. They can be used by investors, companies, or even governments to protect themselves from risk. Investors can use derivatives as a strategic tool for managing risk and making profits simultaneously by diversifying their portfolios to reduce risk as much as possible.
