Exploring financial derivatives can be a tricky prospect. The term "derivatives" encompasses many different types of financial instruments, so truly understanding derivatives requires you to understand all these underlying instruments. The two main types of derivatives that the average investor is likely to encounter are options and futures.
Financial derivatives explained: options
Options are one of the most popular types of derivatives, and they're handy in a variety of applications. Typically, options are derivatives that are structured in such a way that you pay a premium for the option to buy a certain number of units of something at a certain price. If the price of that commodity goes up, you could buy it at the option price and immediately sell it and make a profit. Agreements to buy at a certain rate are known as call options.
The concept of options applies to selling commodities, too. With a put option, an investor agrees to sell a commodity at a certain price. If the market falls, the investor can buy the commodities directly from the market and sell it for the price agreed in the put option, turning a profit. However, if the price of the commodity goes up, the investor is still obligated to sell at the price agreed to in the put option, so the investor could lose money on the deal.
Financial derivatives explained: futures
Futures are contracts to buy a certain number of units of a commodity at an agreed-upon price at a specific date. Futures vary from options in that when you buy options, you are not obligated to follow through; if prices aren't favorable, you can forfeit the deal and lose only your premium. With futures, however, you're obligated to go through with the deal regardless of market conditions, even if it means you'll lose money.
Uses for financial derivatives
Investors buy derivatives for one of two purposes: either they're speculating about the performance of the market in the future, or they're hedging against the possibility of a loss. The way in which you intend to use derivatives influences your derivative investment strategy.
If you're hedging, you'd buy derivatives as a kind of insurance policy. By having derivatives in place for a nominal fee, you can be certain of buying or selling at a certain price, and you don't have to worry as much about fluctuations in the market. Many corporations use derivatives to hedge against fluctuations in interest rates, foreign-currency exchange or the cost of raw materials.
Speculation is a different side of dealing in derivatives. Investors who engage in derivative speculation have no real interest in the underlying commodities, but instead are trying to predict the behavior of the stock market to make a profit. Unfortunately, derivatives can be manipulated in ways that make speculation dangerous to the economy. The government has some regulations in place to protect against speculative manipulation of the market, such as prohibitions against naked short selling, but it can still be a dangerous practice for the economy.
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