Financial Derivatives Investing
Derivatives are a way to reduce the risk of an investment by insuring, or hedging the risk. For those who are looking to invest or speculate without the ability to actually buy or invest, the value is 'derived' from the actual asset of the transaction. When considering the different types of strategies to use when investing, derivatives trading in futures and options are worth a thought. Derivatives are simply an instrument that derives its value from the investment into another asset.
Vanilla derivatives are a name given to the wide variety of simple, common derivatives that are exchange traded. Exotic derivative is the term that describes the more intricate and complicated derivatives as well as the normal 'vanilla' derivatives.
A future trading is one option, which is essentially, where a future stands for a contract to purchase an asset, commodity, or security in the future at a specific price. The terms are put forth and determined by the end date of the contract. The value is derived from the profit or loss made on the item's move in price. This works by the principle of agreeing to purchase, for example 2,000 contracts of cotton at $1 USD each within a three-month period. If, in three months the contracts have appreciated, or risen in value, to $4 USD, the 2000 contracts can be purchased for the agreed upon amount of $1 USD per contract ($2000), and then sold for $4 USD per contract, for a profit of $6000 USD. However, if the market value falls below the agreed upon price, the investor has incurred a loss.
With options trading, it is a similar derivative to futures trading, but with options, the trader can choose not to purchase the agreed upon contracts on the settlement date of the contract. The price of the 'option' is that the trade must pay a premium to the contract writer. If the future value is favorable to the trader the purchase is made, but if the future value decreases and would prove to be a loss for the trader, the trader simply forfeits his or her premium and incurs only that amount as a loss. There has been some criticism to the derivatives market, which has called for some increasing regulation by the U.S. government as it has been shown that misuse of the market can be detrimental and lead to higher costs for American citizens.
There are benefits and risks to this type of investing as potentially huge losses can be incurred when leveraged investment techniques are employed. There have historically been many loses of enormous size and can occasionally render investors at risk of counter-party risk. Benefits of this type of derivatives trading can be the potential positive force this has upon the economy. Even though someone loses money each time someone else succeeds with derivatives trades, it does not affect the economy in a negative fashion. In addition, Alan Greenspan, noted former chairman of the Federal Reserve Board has suggested that the use of derivatives investing can actually soften economic downturns.