What are derivatives? Derivatives simply explained! (2024)

Derivatives are among the most complex investment products on the market and are criticized, not least because of their risk. We will explain to you what a derivative is, what types of derivatives there are and how they work.

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What you should know

  • Derivatives are financial products that reflect the price of an underlying asset. Underlying assets can be, for example, securities such as bonds or stocks. However, a derivative can also be derived from price or interest rate developments, raw material prices, key figures or indices.
  • The family of derivatives includes financial products such asStock bonds, Swaps,Futures,Certificates,Optionsor warrants andCFD (Contract for Difference).
  • Derivatives are mainly used by private investors for speculation. However, for some investors they also serve to hedge against currency and price risks.

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This is how you do it

  • Find out about the nature and functionality of derivatives and be clear about your investment goals.
  • Check the product’s fee structure before investing.
  • If you decide to buy a derivative, you can do this, for example, via an online broker and therefore via the stock exchange. Derivatives can also be purchased OTC, i.e. over the counter through a bank.
  • You can find the best broker in oursDepot comparison.

What is a derivative?

Derivative is the generic term for many different financial instruments. The name comes from the Latin word “derivare”, which means nothing other than derivation. The name describes quite well how derivatives work.

A derivative is a financial product whose price is derived from an underlying product such as a security, a currency or a commodity. However, a derivative can also be derived from price or interest rate developments, raw material prices, key figures or indices.

How much a derivative costs depends on the price of an underlying asset on which the derivative is based. Depending on how the price of the underlying product develops, the investor benefits or suffers losses. Unlike buying stocks directly, for example, you can also bet on falling prices with a derivative.

Trading in derivatives is not a modern invention, but is several thousand years old. As early as 8000 BC In the 4th century BC, traders and producers concluded contracts (futures contracts) with each other, with which they protected themselves, for example, against the decline or increase in prices for certain products. Today's certificates can be traded both on the stock exchange and over the counter (OTC).

What types of derivatives are there?

The group of derivatives includes several financial products. The most important ones at a glance:

Options

OneOptionTo buy means to secure the right to acquire an underlying asset at a predetermined time and at a predetermined price. The actual purchase of the underlying asset lies in the future, which is why options are also referred to as futures transactions. Options or warrants represent a right, but do not obligate purchase.

Futures / Terminkontrakte

Futures, also called futures contracts, work in a very similar way to options - with the difference that they are binding. If you purchase a future, you can no longer withdraw from the purchase of the underlying asset. The only way to avert the whole thing is to resell the contract, which is called closing out the position. With futures you can bet on the price development of a wide range of underlying assets, including raw materials such as wheat and oil, but also stocks or entire stock indices.

Certificates

Certificates are debt securities issued by banks. Unlike options, for example, certificates have an issuer (the bank). So there is an issuer risk. Just like with options or futures, investors use certificates to bet on the performance of a specific underlying asset, for example a share, an entire stock index, a bond or a raw material. One form of certificates, for example, are ETCs (Exchange Traded Commodities), which investors can use to invest in raw materials. A certificate bundles several future contracts and can have different terms.

Contracts for Difference (CFDs)

AtCFDs(Contracts for Difference) investors practically bet against their broker on the price development of an underlying asset. For example, if the investor bets on a falling share price and the price actually falls after the contract is concluded, the broker owes the investor the difference to the initial price. CFDs cannot be bought from classic online brokers, but only from CFD brokers and only over the counter.

Swaps

Roughly speaking, in a swap transaction (exchange transaction), two parties agree to exchange cash flows such as interest rates over a set period of time. Here, too, it is about betting on positive or negative price or value developments.

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What can you invest in with derivatives?

Derivatives allow you to bet on the performance of a wide variety of underlying assets. The most important ones at a glance:

  • Securities (stocks, bonds or entire indices)
  • Foreign exchange (official currencies and cryptocurrencies)
  • Trade goods (raw materials such as oil, wheat, coffee or precious metals such as gold and silver)

How does a derivative work?

Trading a derivative is, broadly speaking, nothing more than a bet on which you can be right or wrong. The different types of derivatives carry different levels of risk depending on the leverage of the product. Derivatives can be used both for speculation and to protect against fluctuations in value.

Derivatives for speculation

Derivatives give investors the opportunity to invest in a security or commodity without owning it. It is possible to provide the investment with leverage, i.e. to multiply the fluctuations in value. This can sometimes increase profits tenfold, but it can also result in a total loss.

Leveraged derivatives work as follows: For example, if you want to bet on a rising oil price, you can buy a derivative on the oil price. Here you first have to decide whether you want to bet on a rising price (long) or on a falling oil price (short). If you choose a certificate without leverage or a leverage of x1, the value of your derivative will rise or fall just as quickly as the price of oil.

Let's illustrate this with a simplified example that ignores fees or safety reserves: Let's assume you buy a derivative for €50 and the oil price is €100/barrel. Shortly afterwards it increases by 5%, a barrel of oil now costs €105. The value of your derivative also increases by 5%, it is now worth €52.50 - you have made a profit of €2.50. However, if you choose a leverage of x20, your bet will be multiplied by 20. In concrete terms, this means: Even though you only have €50, the broker invests €1,000 for you (you are essentially borrowing the money). If the price increases by 5%, your profit is €50 (as much as you “actually” staked). If the price falls by 5%, you lose €50 and therefore your entire stake. In the end, 5% performance means 100% performance for you. (5% x 20). Leveraged derivatives ultimately maximize the price fluctuations of the underlying asset in which you invest. This can work well and bring you rich profits, but it can also mean ruin. Losses will eventually also be multiplied.

Risk protection (hedging)

There is not always a desire for risk behind trading derivatives, but often the exact opposite: a high need for security. Many investors use derivatives to protect themselves against price fluctuations, price drops or price explosions. In technical language, this risk protection is called “hedging” and is carried out by both institutional and private investors; commercial and industrial companies also sometimes use hedge transactions.

Hedge transactions can be set up, for example, via futures and options on the stock exchange or over-the-counter markets. The idea is to secure the price of a particular commodity or security for the future.

Let's look at this with a simple example: A wheat farmer wants to avoid having to sell his wheat for less at the end of the year because the price of wheat has fallen. He would like to receive €200 per ton to be able to cover his expenses. For this purpose he buys a future, which guarantees him that the price of his wheat will be €200 per ton at the end of the year.

His counterpart is a biscuit factory that buys wheat for production. The company wants to protect itself from having to pay more than €200 per ton for the wheat at the end of the year. Both parties agree on a fixed price of €200 per ton of wheat at the end of the year. Depending on how the price develops, one of the two trading partners will have made a good deal at the end of the year. For example, if the price falls, the wheat farmer can count himself lucky: he has protected himself against exactly this risk with the hedge business. The biscuit factory is likely to be annoyed: it would have made a better deal without the hedge business. If the price rose, it would be exactly the opposite: the farmer would be annoyed because he would actually get more for the ton, while the biscuit factory would be happy not to feel the price increase.

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Future business in everyday life

Future contracts are purchase contracts that only become due in the future. In our private lives, far away from the financial markets, we carry out such transactions, for example when booking a trip: for example, we secure a certain price for a plane ticket a few months in advance. When the flight price increases a few weeks later, we are happy that we got a good deal. However, if the price then drops, we get annoyed about the euros we supposedly paid too much. Ultimately, this contract is not about making a profit or doing a particularly good deal, but rather about planning security: you secure a seat on the plane at a certain price.

Investors also use hedge transactions in the foreign exchange market (Forex) to protect themselves from possible exchange rate risks. This is relevant, for example, for companies that do business across national borders. Assume that a German pharmaceutical company primarily supplies the USA and makes most of its sales there. If the dollar weakens compared to the euro, this means a decline in sales for the pharmaceutical company. To protect himself from this scenario, he uses a derivative on the euro and can thus partially or completely offset his losses if the dollar actually weakens.

Conditional and unconditional futures

Not every contract that two parties conclude using a derivative has to actually be honored. A distinction is made between conditional and unconditional forward transactions.

Unconditional forward transactions

This refers to derivatives that must be executed in any case. With such a derivative, both parties commit to honoring the contract and neither can exit early. Unconditional forward transactions are realized, for example, using futures or swaps.

An example of an unconditional swap derivative: Company A pays a fixed interest rate of 3% for one year on its loan. Company B has also taken out a loan and is paying a variable interest rate. Because company A believes that interest rates will soon fall, it would like to have the variable interest rates of company B for a year. Company B, on the other hand, believes that interest rates will rise and would rather protect itself with a fixed interest rate. So the two get into business and swap their interest rates. The above examples of oil and wheat prices are also an unconditional derivative that must be executed in a binding manner.

Conditional futures

In contrast, with conditional forward transactions there is no obligation to perform the service. The holder of the derivative only has the option, but is not obliged, to carry out the service. If the farmer in the example above had bought an option on the price of wheat and the market price rose above the agreed €200 by the end of the year, he could let the option expire and sell it at the higher price. But this choice also has its price: thisOptionTo have the option premium, the farmer would have to pay the biscuit factory (the issuer of the option) an option premium up front, regardless of whether the wheat farmer later uses it or not.

The risks of derivatives

Conditions

Derivatives are very complex financial products whose nature must first be understood. Depending on the type of derivative, different conditions are set for the futures transaction. For example, investors should pay attention to the extent to which they participate in losses or profits and what demands the issuer will make, for example in the case of certificates. For some derivatives, a margin, i.e. a security advance, must be deposited in advance, which serves as a kind of security. How much the counterparty can demand in the event of a loss and when an obligation to make additional contributions is due should also be studied in detail.

Cost

For many products, it is not immediately clear what costs will be incurred. Brokers and banks that issue derivatives want to earn something from issuing financial products. They do this, for example, through a spread that is unfavorable for the buyer, i.e. an unfavorable margin between the purchase price and the sales price. Especially with smaller companies, it is not always easy to get a counterparty for the derivative, so you have to expect higher spreads, as if you were investing in a large ETF that is traded dozens of times a second. Especially with options, there is also an option premium, which can vary in size.

Total loss and much more

Derivatives are highly speculative investment products and many of them can drive their buyer to financial ruin. After all, with some products such as options you can lose more than was invested in the first place. The risk is therefore infinitely high and is not limited to a maximum of 100%, as is the case with the traditional purchase of a share.

Rolling losses and issuer risk

Some investors risk losing money in other ways. Future-based certificates in particular can lead to rolling losses, for example. Futures contracts generally have maturities - in a long-term investment, an “old” contract is always exchanged for a “new” contract. This “rolling” into a new contract can mean additional costs for the investor.

Certificate buyers also risk that the issuer of the financial product, i.e. a bank, goes bankrupt and the invested capital flows into the insolvency estate. This fate befell a number of private investors who had bought certificates from Lehman Brothers during the 2008/09 crisis. Deposits in certificates are not considered special funds, as are deposits in ETFs.

criticism

The global derivatives market has now swelled to more than $600 trillion - ten times the global gross national product (GDP). The number makes it clear that derivatives are no longer just used to hedge risks, but primarily as speculative instruments. You bet on quick profits with currencies, stocks or raw materials. And that in turn always attracts criticism. Particularly in the area of ​​raw materials, the formation of price bubbles can have serious effects on the real world: If agricultural raw materials such as wheat, sugar and corn are artificially made more expensive through speculation, this can lead to famine catastrophes in already poor regions.

Conclusion

It remains to be seen at this point whether banks, hedge funds or institutional investors are rightly in disrepute. The fact is that derivatives in themselves are nothing more than tools that can be used to achieve various goals. They can be a great help for entrepreneurs and traders, but also for risk-conscious investors, by enabling additional security. How and for what purpose derivatives are used is in the hands of their buyer, who can of course speculate with them if they want. Provided you want to take the risk.

frequently asked Questions

How can I buy derivatives?

Are there different forms of derivatives?

What kind of products count as derivatives?

As an expert in financial derivatives, I can provide a comprehensive understanding of the concepts discussed in the article. Financial derivatives are complex investment products that derive their value from an underlying asset. Let's break down the key concepts mentioned in the article:

  1. What is a Derivative?

    • Derivatives are financial products that mirror the price movements of an underlying asset, which can include securities like bonds or stocks.
    • They can also be derived from changes in prices, interest rates, commodity prices, financial indicators, or indices.
    • Examples of derivatives include stock warrants, swaps, futures, certificates, options, and CFDs (Contract for Difference).
  2. Types of Derivatives:

    • Options: Provide the right to buy or sell an underlying asset at a predetermined price within a specified timeframe.
    • Futures / Terminkontrakte: Similar to options but with an obligation to buy or sell the underlying asset.
    • Zertifikate (Certificates): Debt instruments issued by banks, representing an investor's bet on the performance of an underlying asset.
    • Differenzkontrakte (CFDs): Contracts where investors speculate on the price movements of an underlying asset.
    • Swaps: Agreements between two parties to exchange payment streams over a set period, often used for hedging.
  3. How to Proceed:

    • Investors are advised to understand the nature and functioning of derivatives and clarify their investment goals.
    • Examination of the fee structure of the product before investing is crucial.
    • Derivatives can be bought through online brokers or over-the-counter (OTC) through a bank.
  4. Derivatives in History:

    • The history of derivative trading dates back thousands of years, with early forms of contracts to hedge against price fluctuations.
  5. What Can You Invest in with Derivatives?

    • Investors can use derivatives to speculate on the price movements of various assets, including securities, currencies, and commodities.
  6. How Do Derivatives Work?

    • Derivative trading involves making speculative bets on the future price movements of an underlying asset.
    • Derivatives with leverage can amplify both gains and losses, allowing investors to profit from market fluctuations.
  7. Risk Management (Hedging):

    • Derivatives are not only used for speculation but also for risk management (hedging) purposes.
    • Investors use derivatives to protect themselves from adverse price movements, such as fluctuations in currency exchange rates or commodity prices.
  8. Types of Derivative Contracts:

    • Unconditional (Unbedingte) Derivative Contracts: Must be executed by both parties.
    • Conditional (Bedingte) Derivative Contracts: Provide the option but not the obligation to execute the contract.
  9. Risks of Derivatives:

    • Derivatives are highly complex products, and their conditions vary.
    • Costs may not be immediately apparent, and investors should be aware of potential fees.
    • Derivatives carry the risk of total loss, and some products may lead to infinite losses.
    • Roll losses and issuer (emittenten) risks are additional concerns.
  10. Criticism of Derivatives:

    • The global derivative market has grown significantly and is criticized for being used more for speculation than risk management.
    • Excessive speculation in commodities through derivatives can lead to price bubbles with real-world consequences.
  11. Conclusion:

    • Derivatives are tools that can serve various purposes, from risk mitigation for businesses to speculation for investors.
    • The use and purpose of derivatives depend on the buyer, and engagement with derivatives involves accepting associated risks.

Frequently Asked Questions:

  • Investors can buy derivatives through online brokers or over-the-counter through a bank.
  • Yes, there are different forms of derivatives, including options, futures, certificates, CFDs, and swaps.
  • Products like options, futures, certificates, CFDs, and swaps fall under the category of derivatives.
What are derivatives? Derivatives simply explained! (2024)

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