How does it work?
Derivatives are financial instruments whose value depends on the value of an asset (the underlying). As the name indicates, the value of the derivative is derived from the value of the underlying. They are created through contracts between investors that specify certain rights and obligations. The most common derivatives are forwards and options. A forward, for instance, is a contract that obliges one party to buy a specified asset at a certain point in time for a pre-defined price. Simultaneously, it obliges the counterparty to sell the asset for the same conditions.
In the world of options, the buyer has the right, but not the obligation, to buy an agreed quantity of the underlying from the seller of the option at a particular time (the expiration date) for a specific price (the strike price). The seller (or "writer") is obliged to sell the commodity or financial instrument to the buyer if the buyer requests it. The buyer pays a fee (called a premium) for this right. The most common options are puts and calls. The term "call" comes from the owner having the right to "call the stock away" from the seller. The word, put, refers to the right to give the asset away.
The gain or loss incurred by each party depends on the agreed-on price and the asset's actual price at contract maturity. A special version of a forward is the future, a standardized forward traded on an exchange.
How do derivatives make money?
Derivatives are often called a zero-sum game. This means that, slightly simplified, one party's gain equals the other party's loss. However, this is true only in an economic sense and following a narrow, purely financial definition of gains and losses. In practice, there can be several legitimate motivations for using derivatives. Taking a long position in a forward contract, for instance (the obligation to buy the asset), provides an investor with similar exposure to the underlying asset as a position in the underlying itself. If the underlying asset (for instance, a basket of stocks) appreciates, the investors make money. So why would anybody take the opposite position (short position or obligation to sell the asset)?
One reason is that your counterparty believes that the underlying is overpriced and will depreciate in the near term. The short position may also be one part of a more complex strategy. Beyond this, derivative contracts are used widely for risk management. An investor who holds a risky asset but wants or needs to reduce risk may sell the asset. It may, however, be cheaper and faster to take a short position in a derivative contract instead. Derivatives on commodities are essential for operators in many industries. An airline, for instance, may protect itself against sudden increases in fuel prices that could threaten its financial plans. At the same time, an oil producer may seek insurance against a decrease in fuel prices. In this case, both parties benefit from better visibility of future revenues and profits.
How risky is this asset class?
It depends a lot on the derivative and how it is used. The risk of a long position in a forward contract, for instance, is comparable to the risk of a similar position in the underlying asset. Therefore, a forward on a basket of stocks is riskier than a forward on a basket of government bonds. A (naked) short position in the same contract is much riskier as the maximum loss possible is theoretically unlimited. If the short position in the derivative is combined with an investment in the underlying asset, however, the resulting portfolio is risk-free as both positions offset each other.
Another critical risk in derivatives is counterparty risk. As outlined, derivatives are essentially agreements between two parties. It is thus crucial that the parties are able to fulfill their obligations under this agreement.
Assume you bought a put option on a stock that trades below the strike price. The put option is in the money. The option' seller is thus obliged to buy the stock from you at a higher price than the market price. However, this claim becomes worthless if the seller has no money to pay you (default).
Various rules have been implemented to make this event relatively unlikely. This includes the obligation to deposit a certain amount of collateral (margin).
Furthermore, there are generally two types of derivatives. The first category is traded directly, so-called over-the-counter (OTC) through a broker-dealer network. Derivatives that fulfill specific requirements can or in some cases have to be traded through a Central Counterparty Clearing House (CCP). The CCP is an institution that guarantees the terms of the agreement even if one party defaults on it and thus eliminates the counterparty risk between the two.
Many investors are afraid of derivatives due to their bad reputation and because they seem complex. They have often been misused by market participants playing va banque or by investors lacking the required know-how and understanding.
Why is it important for my portfolio?
The derivatives market is the biggest in the world. This is because the value traded through derivatives is much bigger than the underlying value for many assets. This makes it highly liquid, meaning that investors can get in and out of positions in derivatives much faster and cheaper than if they traded the underlying itself. This allows you to manage risks very precisely and, for instance, quickly reduce exposure to an asset.
Because derivatives can, in principle, be created easily on all kinds of assets, they make assets investable that otherwise would be almost impossible to trade (especially commodities such as oil, cattle, etc.). Derivatives can therefore allow you to take positions in such assets.
Derivatives like options can equally be used to seek higher returns or reduce risk. They can also be an alternative source of income. An investor who sells put options, for instance, acts as an insurer and, in return, receives the insurance premium.
How do you approach derivatives investing?
In our wealth management solutions, we use derivatives such as forward contracts to reduce risk. For example, investments in foreign assets come with the risk of a depreciation of the foreign currency. With the help of FX forwards, we can protect the portfolio against such an event. We may also use forwards to invest in assets such as to save government bonds where it is more common, easier, and cheaper to trade in the future.
As a wealth management boutique with extensive experience in alternative strategies, we frequently create unique strategies for our professional investors. This includes trading strategies that attempt to profit from short-term market moves or yield enhancement strategies that generate extra returns by selling options.
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