Is there an advantage to using derivatives

Derivatives

What are derivatives?

Derivative comes from Latin and means: the derivative. In finance, a derivative is a product whose price and result are derived from the development of another financial instrument. This is known as the underlying. In terms of their legal structure, financial derivatives are bonds issued by an issuer, the credit institution. However, the value of these papers does not depend on the creditworthiness of the issuer, as is the case with traditional bonds, but on the benchmark, the reference or base value. If the investor buys a derivative, he is not directly involved in the underlying asset, for example a share, he only invests indirectly in these assets. Investors do not participate 1: 1 in the performance of the reference value, but in any contractually stipulated ratio. The financial sector characterizes transactions with derivatives as futures or stock market futures. This means: the seller of the derivative guarantees to deliver a defined financial instrument to the buyer at a certain time at the agreed price or to bring about financial compensation in cash.

What types are there?

Financial derivatives can be differentiated according to different aspects: according to their purpose, the market expectation of their buyer and the underlying assets to which they refer. In addition, they can be grouped according to place of trade, performance claim and performance obligation. Derivative financial instruments are used to hedge custody accounts against price losses, to take advantage of price differences on stock exchanges, to speculate on certain price developments or to generate an exorbitant profit using leverage on a small investment amount.

Traders and investors use derivatives to speculate on rising prices for securities or foreign exchange, for example. The construction of the financial instruments enables investors to disproportionately participate in the profits of the underlying asset. However, it is also possible to benefit from falling prices. If the price of the underlying asset falls, the price of this derivative increases in the specified ratio. Investors can find various derivatives online for every market expectation; they can be traded on securities or futures exchanges as well as over the counter. The following financial instruments can be the base value of a derivative:

  • Securities such as stocks and bonds,
  • Money market instruments, for example short-term bearer bonds and promissory note loans,
  • Interest rates or other income such as dividends,
  • Indicators such as indices and ratings,
  • Trade items, such as goods, raw materials and precious metals,
  • Currency.

Unconditional forward transactions are associated with the requirement to deliver financial instruments at a certain point in time or to settle the difference in the transaction. These include fixed and swap deals. Conditional futures contracts offer the purchaser a right to choose who can or cannot take advantage of the range of services, these are options. The buyer of an option can, depending on whether it is worthwhile for him, buy or sell a certain amount of the underlying at a fixed price at the time of maturity or during a defined period of time. An example of options are warrants. Fixed transactions must be fulfilled on a date, the buyer must transfer a certain amount, the seller must deliver the agreed reference value at the contract price or pay a cash settlement. If, in the meantime, prices have risen on the market from the time of purchase, the buyer benefits, and if prices have fallen, the seller of the derivative wins. Fixed deals include futures or mini futures, reverse convertibles, knockout certificates, discount certificates, forex trading instruments and CFDs (contracts for difference). In swap transactions, payment flows, for example fixed and variable interest rates, are exchanged between two contractual partners at several points in time. They are mostly reserved for institutional investors.

What are the advantages of derivatives?

By participating in the development of the base size, investors can achieve a disproportionate profit even with a small investment. Derivative financial instruments make it possible to hedge against specific risks associated with papers or trading objects. For example, if the stock markets go down, a successful bet on falling stock prices helps to limit or even compensate for portfolio losses. Derivatives are also of great economic importance. Companies can use financial derivatives to hedge against exchange rate fluctuations or changes in the price of raw materials. For example, farmers can protect themselves from falling wheat prices. With derivatives, investors can also map complex investment strategies.

What risks do buyers need to be aware of?

The cost structure of derivatives is sometimes just as confusing and intransparent as the range of these financial instruments. In the case of financial derivatives, one cannot speak of long-term investing, it is largely a matter of short-term speculation to maximize profits or a hedging strategy to avoid high price losses. Private investors must always expect the total loss of their capital, with futures the buyer must fear an unlimited potential loss (obligation to make additional contributions). Without trading experience, private investors should exercise caution with derivatives. Forex currency trading in particular, with bets on currency pairs, can generate the highest losses. Potential traders should use the help offered by online brokers and direct banks in the form of demo accounts in advance. Leverage products have very high risks because the credit-financed speculation increases price losses within a short period of time. It is therefore advisable to initially only risk small amounts invested in derivatives. Only private investors who can afford a complete loss of their assets and enjoy financial bets on price developments should trade in derivatives.

Summary:

  • Derivative: financial product whose price and performance are derived from the underlying
  • Derivatives can be used to hedge custody accounts against price losses, to exploit price differences between stock exchanges, to speculate on certain price developments or to generate enormous profits by leveraging a small amount
  • Contractual agreement between buyer and seller to settle the transaction through delivery of the underlying asset at the agreed price and date or in cash
  • Underlyings can be stocks, bonds, commodities, precious metals, currencies, indices, interest rates
  • A distinction is made between fixed and swap transactions, and options with derivatives can be set on rising and falling prices, thereby protecting a portfolio against loss of value
  • High chances of winning entail great risks: Traders and investors need to understand how derivatives trading works, terms and conditions, and consequences
  • Financial derivatives are not suitable for newcomers to stock market trading and should only be traded by experienced traders who are well versed

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