Derivatives: Options, Futures, Others
An Easy Derivatives Tutorial
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Derivatives Definition
A derivative is a financial instrument derived from an underlying asset, eg a stock, stock index, currency etc. Derivatives allow holders to speculate on price movements of the underlying asset without actually owning the asset concerned.
Derivatives are traded for two main reasons:
1) to allow holders to hedge a position, ie to reduce the risk inherent in their basic position;
2) to allow speculators to profit from correctly anticipating price movements.
Speculator profits essentially come from the premium paid by hedgers for reducing their risks.
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Derivatives are usually highly geared, with a small percentage change in the price of the underlying asset producing a much larger change in the derivative price. This gearing is further increased traders trading on margin, ie depositing only a fraction of the value traded (the margin) with their broker. It follows that derivatives offer a much higher potential for profit - and also loss - than direct investments.
The main types of derivatives are:
- Options - the right to buy/sell an asset at a particular price some time in the future.
- Futures - the oblgation to buy/sell an asset at a particular price some time in the future.
- SWAPS - two parties agree to swap financial arrangements with each other to mutual benefit, eg an institution with a fixed interest debt that believes interest rates will fall would swap its arrangement with another institution with variable interest rate debt that believes rates will rise.
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