What are derivatives? Learn more about the 5 most important aspects
What are derivates? A derivative describes a "descendant" or a subcategory of something that already exists. Also, in the financial world we can talk about financial derivatives. In the following article, you will find out what you should know about derivatives and why you should not jump into the auspicious world of CFDs, options and similar high risk assets. (according to advertisers). By the way, day traders should also be aware of the risks mentioned.
What exactly are financial derivatives?
Financial derivatives are financial instruments that are contingent on a given underlying asset, (depending on the use and nature of the derivative) which rise or fall in case of price losses or price increases.
Underlying assets may include, for example, equities, commodities, funds or the like. It can be considered as a bet, whether an asset will gain or lose value. We can say, that it is an indirect investment and in very speculative financial products.
If we are talking about gamblers in the stock market (justified or not), financial derivatives are one of the reasons for this perception.
Where do financial derivatives come from?
Most financial derivatives are future contracts as they have future due dates. Historically, today’s financial derivatives originated hundreds of years ago. Back in the seafaring days, world trade had already been a very solid business, but also highly uncertain as many dangers lurked on the high seas:
If a ship was at sea for a long time and a war broke out (unbeknownst to the crew), suddenly that “friendly nation” would become an easy victim to their new enemy on land.
Aware of such uncertainties, some traders agreed on futures. They agreed on a certain purchase quantity and price of a good to be transported and the price would be paid on delivery.
The recipients had the certainty that a shipment was on the way to them and that is was supposed to arrive in a predetermined period in agreed quality and quantity.
The shipowners on the other side had the certainty that their goods would be received at the destination according to the prior agreed price. So, basically it was about hedging.
How are financial derivatives generally used?
Financial derivatives allow investors to participate at the performance of an underlying asset without having to hold the shares themselves. Profit is even possible if the performance of the underlying asset is negative, provided that one has set on it.
This form of participation in performance is interesting because the purchase of the corresponding derivatives is usually much cheaper than the actual acquisition of the underlying asset. Therefore, it is a market that has no high demands on available capital. Seemingly!
Most derivatives work with levers. They do not reflect 1: 1's performance of the underlying asset, but can be analog 2: 1, 3: 1 or even in a far higher ratio. The performance is highlighted exponentially, which offers huge return opportunities.
However, the same happens the other way around as well! If the underlying asset develops against one’s own speculation, there can be corresponding losses according to the leverage effect. That can turn into an ugly situation, especially when it comes to additional payment liabilities. It is possible that at the end one loses more than the initial capital.
Institutional investors (banks, insurance companies, etc.) use certain financial derivatives for hedging, in the event that the price of one of the underlying assets held by them develops unfavorably.
What types of financial derivatives are there, how do they differ?
Financial derivatives are a very differentiated and complex market and include numerous variations nowadays:
When are financial derivatives recommended?
Actually, financial derivatives are never recklessly recommended. They are potentially very risky. In particular, leveraged financial derivatives are clearly only intended for certain risk-taking or at least very competent investors.
Generally, you should never get involved in a financial product that you do not fully understand.
This applies even more so with derivatives!
Although these can supplement the hedge against losses of the underlying asset or be used in the corresponding assets to offset negative currency and interest rate developments.
However, it does not change the fact that they remain a rather delicate financial instrument.
It is due to the numerous online brokers on the internet that financial derivatives are now advertised very aggressively - especially to private investors. The online brokers are specialized in certain financial products like options, binary options and cryptocurrencies like bitcoin want to make the topic tasty for everyone.
While financial derivatives can indeed be a potent financial instrument in trained hands, and can moderately also be used for hedging, they are certainly not the most suitable experience for aspiring investors and day trading beginners.