How do derivatives work?

If you have ever taken finance classes or are even vaguely familiar with finance, you have likely heard of derivatives.  But what are they and how do they work? This article will attempt to explain that. This article is for you if derivatives interest you, so read on to learn more!

What is a derivative

If you read a modern finance textbook, you will likely come across a sentence worded like this, “A derivative is a contract whose value is based on an underlying financial asset, security, or index.”  What this means is that you are buying an item whose value is based on another item.  

How do derivatives work?

A futures contract is generally used to guard against risk.  The risk in most of these instances is the value of the underlying asset mentioned in the contract decreasing in value.  For example, if you trade in tech stocks and you are buying a certain number of shares in Samsung, you may enter into a derivatives contract where you buy a certain number of Samsung stock shares, perhaps 600, at its current value of $30 a share at a future date, perhaps six months from now.  You currently own $18,00 worth of Samsung stock.

Your hope is that in six months time, each share of Samsung stock will be more than $30 a share allowing you to make a decent profit off of your derivatives transaction.  

How to use derivatives

Traders and people who deal with stocks generally use derivatives like one would use an insurance policy – to guard against unforeseen future risk.  Farmers can also use derivatives to guard against this type of risk.  For example, a corn farmer can use corn derivatives to guard against the unanticipated but entirely possible risk which would come from locust swarms invading and eating their crops.  The corn farmer would be left with nothing if this were to occur

There are two main ways to trade derivatives:  

  • Over the counter
  • Through an exchange

When derivatives are traded over the counter, they are unregulated and are more risky.  Their returns are greater because they are much riskier.  

When derivatives are traded through an exchange, they are standardized.  They tend to be worth less and have returns of much lesser amounts. The trader is much more assured that he or she will actually receive his or her return at the stated value because their underlying value is much less.  

To conclude

Derivatives are a valuable trading instrument provided you (the investor) are knowledgeable about the derivative and the market which you are trading in.  many people have made and continue to make a fortune by trading derivatives. If you do more research, you can easily become one of these people!

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