What You Should Know About Investing with Derivatives
As we’ve previously mentioned, derivatives are a type of financial instrument used by advanced traders. The values of these instruments are based on a set of underlying assets, causing them to be more complex in nature. Let’s start by discussing the different types of derivatives available to traders.
What are the different types of derivatives?
Options: These represent a right to claim on assets at a specified price and later date.
Futures: These represent an obligation to a claim on assets at a certain price in the future.
Forwards: These are essentially the same as futures with one difference – they are traded over-the-counter, rather than on an exchange.
Swaps: These represent an agreement between two parties, where the cash flows on particular assets are exchanged for those owned by the other party. You essentially receive the cash flows from their assets, while they receive the cash flows from your assets. These are traded in over-the-counter markets, rather than on an exchange.
Warrants: Warrants basically represent long-term options, since most options are only valid for a maximum of one year. These are traded in over-the-counter markets.
Baskets: These are comprised of a portfolio of options.
A little more on swaps.
There are two main types of swaps:
Interest Rate Swaps: This is where two parties exchange cash flows that are generated from interest payments. Thus, one party typically assumes that interest rates will rise, while the other assumes they will drop. Also, one party’s cash flows are usually determined by a fixed interest rate, while the other is determined by a floating interest rate. The party who thinks interest rates will rise usually seeks to swap their fixed rate for a floating rate. This is because a floating rate will adjust to the future higher interest rates and provide greater cash flow than the fixed rate. On the other hand, the fixed rate is sought out by those who think interest rates will fall, since they are guaranteed the previously higher rate.
Currency Swaps: These occur when two parties agree to switch cash flows of different currencies. For example, if one trader has cash flows in US dollars, while another has cash flows in Canadian dollars, a currency swap would occur if they trade claims on each other’s cash flows. Again, this typically is a result of two parties with differing views about the future of foreign exchange rates between the two countries whose currencies are involved.
Since these swaps occur for multiple periods at a time, they have been considered to be extensions of futures that reoccur for a number of periods. Specifically, futures are valid for the one transaction, whereas swaps will continue for the number of agreed upon periods.
Where to trade derivatives.
As you’ve seen in our discussion of the various types of derivatives, trading of these financial instruments occur in two primary locations. The first is on exchanges, while the second is in over-the-counter (OTC) markets. Most derivatives trading happens over the counter, often between two parties who know one another. Of course, it’s much more difficult to regulate the OTC markets than it is for those traded on exchanges.
The risks of trading derivatives.
As with all financial instruments, derivatives have risks, including:
Complexity in pricing valuation. Given the complex and intricate nature of derivatives this makes it difficult to arrive at accurate price valuations. Specifically, derivatives are based on the activities of underlying assets, which complicates the valuation process. Since you are essentially betting on certain activities in the prices of these assets, it is difficult to be sure of any valuations.
Limited time frames. When investing with derivatives, you are guessing about the price changes of underlying assets. However, derivatives are only valid for a particular timeframe. This means that you must also be able to predict when these changes will occur, which is very difficult to do. Typically, when you trade derivatives you do not need to provide the full cash amount up front. Instead, you only provide a portion, which technically means you could invest in more derivatives with a total value equal to more than your cash balance. However, this can work to your benefit as much as it can to your disadvantage. It will amplify both gains and losses, which makes it necessary for you to have enough cash on hand to service any losses.
In the end, derivatives are very complex financial instruments and should not be used by inexperiencedinvestors. It takes lots of practice to fully understand the operations of the different types of derivatives, as well as to make surethat you’re using them for the right purpose. With that said, this should only mark the beginning of your education intrading with derivatives.
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