Derivatives or derivative financial instruments are a type of financial contracts which profit, risks and underlying conditions depend on changes in the value of the underlying asset. Options is one of the varieties of such contracts. Their main feature is that they give their owner the right, but not the obligation, to make the deal on specified conditions. The underlying asset can be stocks, currencies and various commodities.
Derivatives as a whole are contracts between two or more parties, which value is based on the base value of the asset or their set. Such agreements can work with bonds, interest rates, market indices, cryptocurrencies, as well as stocks, currencies and raw materials which are typical for ordinary options.
Derivative financial instruments have a maturity date (there are exceptions - perpetual futures, for example) and price. They have two main tasks - either making profit through speculation or hedging an asset or portfolio of assets.
What are the options?
Typically, this term refers to stock options. That means - the opportunity, but not the obligation, to buy shares at a certain price - the "strike price" - on the date the contract expires. The ability to create an option which could be sold is called a “premium." Usually, two main categories are used: “call”, which allows the holder to buy assets, and “pool”, which allows to sell.
Usually, each option implies a batch of 100 shares of a certain company under one contract. Trading is making on exchanges, which guarantees transparency and liquidity of transactions.
There are two main categories of options - “American” and “European”. The first option allows the holder to make a purchase/sale at any time before the deadline, the second - only on the last day of this period. The European options are the S&P 500, and the American are ETFs.
There are other financial instruments besides options. The most interesting are the following:
Futures. Guaranteed agreements on the purchase and sale of a certain product for a certain price at a predetermined moment of time. Usually, it is making on exchanges that have their own “enforcement and compensation mechanism”, since any futures are an obligation to fulfil a contract. Usually, we are talking about specific goods, such as oil, grain or other resources, but there are futures for other assets, up to fluctuations in the exchange rate and weather changes.
Swaps. Usually, it is a cash flow exchange agreements between the two parties. An example is the interest rate and currency swaps. The first option is to “exchange” some interest payments for others while maintaining the total amount. For example, when one company does not need payment with a floating rate, and the other with a fixed rate. Usually, these are private contracts, but recently swaps are increasingly traded on exchanges.
And the law, called the “Dodd-Frank Act”, led to the emergence of full-fledged swap exchanges that ensure transparency of transactions and issue compensation if something goes wrong. The financial crisis of 2008, which also took place due to the fact that many “private” swap contracts were not feasible, which caused a “cascading reaction”, is now unlikely to happen again.
The main reasons why investors using swaps are the following:
- Changes in investment objectives and debt repayment methods
- The using of alternative financial flows and the estimated financial benefits from it
- Variable Rate Hedging
Forwards. The same as futures, but making separately from exchanges. In addition, forwards can be redeemed before the official expiration date. For example, we can consider the following situation. There is a company in the USA that receives a certain amount in euros every month into its account. Which every time you have to convert to dollars. And since the exchange rate is changing, regular receipts in dollars are also changing. But if you conclude a forward contract, you can fix a certain rate for yourself and get a predictable cash flow that does not depend on external conditions.
Forwards can be used both for speculation and for hedging, however, the second option is somewhat complicated. Since this type of contract is concluded privately, and not on the exchange, it has a high counterparty risk - one party’s refusal to fulfil its duties by default. In addition, many retail traders find it difficult to find stable partners for the conclusion of forward contracts.
Technically, options are the only variant of derivative financial instruments in which the contract provides an opportunity to make a transaction, but does not oblige it. Everything else is common. Including the ability to close the contract before its expiration date without exchanging underlying assets. However, this option is fraught with financial losses, both because of the need to pay compensation and because of the possible difference in the cost of reselling the derivative.