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Derivatives, Futures and Options: What’s the Difference?

By: Elite Legacy Education, January 4, 2017

Derivatives, Futures and Options: What’s the Difference?

When it comes to investment choices, the selection is nearly endless. In addition to each of the different asset classes we discussed in a previously article, there are even more financial instruments that you can invest in. These are considered to be among the more technical securities that exist to serve the needs of advanced traders. Even if you’re not on Wall Street, you will benefit from understanding these investments too. They just so happen to go by the name of derivatives.

 

What are derivatives?

No, thankfully we’re not referring to those high school calculus days. The derivatives we’re referring to are a type of financial instrument whose value is derived from the value of another underlying asset. Specifically, this means that the value offered by derivatives is based on the price changes of another security to which its performance is tied to.

If you’re looking to invest in derivatives, you can find some being sold on the over-the-counter market, while others are traded on various exchanges. Over the counter (OTC) refers to private negotiations that aren’t as regulated as those which occur on a public exchange. However, it is worth noting that OTC instruments have become much more regulated following the most recent financial crisis.

Derivatives are a tricky instrument to master, but they also provide a plethora of benefits. These include:

  • Hedging risk
  • Speculating future prices
  • Exploiting arbitrage opportunities
  • Changing the nature of either an associated asset or liability

 

As you can see, the fact that derivatives can be used for multiple purposes hints toward their complexity. However, there are a few different types of derivatives that help to achieve specific purposes in the list above. Options and futures are both a certain type of derivative, which we will discuss in further detail. There are also forwards and swaps but those will be discussed in another article. 

 

What are options?

Besides the fact that options are a type of derivatives, what does that really mean? Well, options represent a contract between two investors. In particular it provides the option buyer the opportunity to purchase the underlying assets at a pre-determined price at some point in the future. It is sold by the option writer to the option buyer. This basically represents an opposing bet by each party about the future of a security.

Options can be used for two primary reasons:

  • Trade Speculation: This refers to betting on the direction of a price change, in this case the underlying asset. The option buyer speculates that future price increases of the underlying asset will occur. On the contrary, option writers are speculating that the asset price will drop in the future.
  • Hedging Risk: This on the other hand, refers to reducing the volatility (i.e., risk) of one’s portfolio. For example, if you are invested in the underlying asset, then you may bet on a price decrease to even out any losses if the price does in fact drop.

 

For everything you need to know about investing in options, read our article here.

 

What are futures?

Again, we know that futures are a type of derivative, but what does that really mean? Well, a futures contract essentially represents a deal to buy an underlying asset at the current price, but at some point in time in the future. Futures are actually quite similar to options, except for one distinguishing feature. Options provide the right to purchase, whereas futures provide an obligation to purchase. Just like options, this represents opposing views between the party issuing the futures contract and the one purchasing it.

Given that they are very similar in nature to options, it’s not surprising that these financial instruments are used for the similar purposes of:

  • Trade Speculation: This is exactly the same as for options. The buyer speculates that prices will rise, while the seller speculates that prices will fall.
  • Risk Hedging: Again, reducing portfolio volatility through risk hedging can be achieved the same way that it would for options.

 

For everything you need to know about investing in futures, read our article here.

 

So there you have it – an introduction to derivatives, futures and options. Stay tuned as we will be releasing in-depth articles for each of these three financial instruments.

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