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 are derivates?

What are derivates?

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: 

  • ​Ships were at the mercy of the wind. Too little wind could have been just as catastrophic as too much wind. If the crew had planned their food supply for a 5 day journey, the absence of wind could have turned the journey into 10 days and no food would have been had.
  • ​Piracy was a recurrent problem.
  • ​Highly uncertain diplomatic relations were sometimes even more dangerous than pirates.

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:

  • Equity warrants - are mostly offered by banks. The warrants allow one to speculate on the future market value of an underlying asset. The acquired warrant defines that in the future one can acquire an underlying asset at a certain price. If the price is higher at this time, you make a profit, by either taking the underlying below market value or let the difference pay out. Likewise, one can speculate on falling courses.
  • Certificates - Certificates are fairly fuzzy defined derivatives that are available in infinite variants. From simple to highly complex financial instruments everything is available.
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    Futures - futures are broadly in line with the previously explained historical model of the futures transaction. It is agreed to deliver a certain scope of services at a certain time. In this case it is a financial product. However, the exchange usually only concerns money. This is the reason why futures are associated with derivatives. They are taken at a predefinedprice. Depending on how the market price is analogous to the agreed price, a party makes a profit or loss.
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    Forex - In Forex trading, derivatives are traded around foreign exchange trading. In the form of currency pairs (e.g. EUR / USD), which reflects their performance relative to each other. Leverage products, such as CFDs are used and most of them are invested on a short term. This is a highly speculative market too.
  • CFD / Differential Contracts - CFDs are short-term performance bets on underlying assets. Also, with CFDs one can speculate on rising or falling courses. They sometimes have the most tremendous leverage and are therefore considered as an aggressive, risky speculation.
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    Binary options - Binary options are banal bets on the course of an underlying asset. You simply bet if it will be more valuable or less valuable as at the time when the bet becomes active. The period of evaluation can be between one minute and several weeks (depending on the offer). If one is right with his assessment (estimation), one benefits accordingly to the offered modalities. Otherwise, at least the major part of the investment is gone.

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.

Conclusion

​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.

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