A Simple, Understandable Explanation of Derivatives

Few words in the world of finance are surrounded by as much confusion, mystery, and misinformation as derivatives. Right off the bat, many derivatives are extremely complicated, so complicated that finance experts will struggle to explain them to you. The basic concept of a derivative, however, isn’t all that complex. So let’s dig in!

First, let’s look at the word “derivative”. It is based on the word “derive”, which is essential for understanding the concept of a derivative. Basically, a derivative is a financial security that derives its value from something else. To explain, we go over both non-derivative and derivative securities so you can see the difference.

Examples of Non-Derivative Securities

Let’s start with non-derivative securities. A stock is an example of a non-derivative security. It derives its value directly from itself. A stock, for example, represents a small (often minuscule) portion of ownership of a company, and possibly any associated dividend payments. Even dividend payments are based directly on that ownership of the company. With dividends, the owners of the company are getting a share of the profits.

A bond is another example of a non-derivative asset. The value comes from the bond itself and the interest being paid back in exchange for loaning money. The higher the risk, the higher the interest rates will be, at least when markets are functioning properly.

Examples of Derivative Securities

So what the heck are financial derivatives and what is derivatives trading? As we already mentioned, derivatives derive their value from something else. Let’s dig in.

Derivatives involve two or more parties, and one or more underlying assets. Often, but not always, the underlying assets on what a derivative is based a non-derivative assets, such as stocks, bonds, and commodities. The value of the assets largely determines the price and value of a derivative.

Option as an Example

Perhaps the easiest and most common example of a derivative is a so-called “option.” An option gives a buyer the right, but not obligation, to buy an asset as a specified point in time at a specified price.

Let’s say you believe Apple Inc is going to rise substantially over the next six months. You could buy options to buy Apple stocks with an expiration date in six months. Meaning that in six months you have to choose to buy the stocks, or you can let your contract expire and never exercise your right. If stock prices rise, you will have the option to buy stocks at a cheaper, already agreed upon price. If stock prices drop, it won’t make sense to buy the stocks, so you will let your options expire.

Options are generally cheaper than stocks, but also higher in risk. If you don’t exercise your right to buy options, you will lose your entire investment.

Derivatives are Like Side Bets

There are many, many types of derivatives. In many ways, you can think of a derivative as a side bet. Two parties get together and “bet” between themselves on the rise or fall of another asset. Often, the parties won’t actually be trading the asset, but instead they settle the difference in cash. With options, for example, the broker might just pay you the difference between your right to buy a stock, and its price at the time of exercising the contract.

Investors can draw up derivatives for weather patterns, political turmoil, and just about anything else. All that is needed, basically, is two different parties willing to draw up a “side bet” derivative contract.

There are also things called partial derivatives, in which one variable can change, but the other variables remain constant. That’s a complex discussion for a different day, however.

How Are Derivatives Traded?

Major investors trade most derivatives over the counter. Institutions often directly trade these so-called OTC derivatives. Goldman Sachs, for example, could arrange for derivatives directly with Deutsche Bank. As a small-time investor, you likely won’t be setting up derivatives yourself, but instead trading them through an exchange. Most large financial brokers can sell you this kind of financial security.

 

Derivatives trading can be a high risk investment. If markets change dramatically, the costs of such financial securities to one or more parties can be extremely high. If we think back to the financial crisis in 2008, derivatives tied to mortgage-backed securities caused a a lot of the trouble. Investors generally consider mortgage-backed securities low risk, so buying derivatives based on them was relatively cheap.

Some banks and investors bought a lot of these derivatives, betting that the MBS’s would fail. They acquired huge numbers of them because they were so cheap. When the housing market collapsed, the companies that backed the derivatives suddenly found themselves on the hook for massive payouts.

Derivatives are not nearly as highly regulated as other instruments, like stocks and bonds. This is partially due to the fact that mostly only professionals and major companies were trading in derivative securities. Many believed that problems in the derivative market wouldn’t affect ordinary traders, though the financial crisis partially disproved this.

Authorities have increased regulation, and the derivatives market isn’t the wild west it used to be, but many people are still concerned over the derivatives market. Certainly, it’s important for investors to keep an eye on it.