Derivatives describe the large group of different asset classes that don't have their own independent value. Instead, the value of these assets is dependent on an underlying asset, thus the value is derived. In our case, an option is a derivative since the value depends on the underlying's price. There are different types of derivatives outside of just options. Let's jump into some common examples of derivatives available.
Other types of derivatives
All derivatives, including options, are contracts to purchase or sell the assets of an underlying at some point in the future. The terms of the contract on what is being bought or sold, how much of it, when the transaction will occur, and at what price can be standardized by an exchange like the Chicago Board of Exchange or negotiated between two parties.
Futures, like options, represent an agreement between two parties on a transaction with the exception that, once in place, the agreement will execute at maturity regardless of the underlying price.
The buyer of the future is obligated to buy the underlying asset and the seller of the future is obligated to sell the underlying asset. Futures are used by investors or companies to hedge against price movements. For example, Tesla may buy a futures contract to lock in the price of lithium used for batteries to hedge against any future increases in price due to limited supply. Upon maturity, Tesla must buy and accept delivery of the lithium from the seller of the contract.
Futures have standardized and fixed maturity dates and are traded on the exchanges. We can benefit from futures without the risk of physical delivery of the underlying to our homes through certain ETFs such as $USO.
Forwards are just like futures, except that the terms are not standardized and are negotiated between the buyers and sellers.
The non-standard terms are traded over-the-counter (OTC) instead of on an exchange. There is currently no way to invest in forwards as an asset class.
A swap is used by banks and large financial institutions to exchange the cash flow or liabilities from two different instruments.
For example, two banks can write a swap agreement where the interest payments of a fixed interest bond are swapped for the variable interest payments of another bond. As an everyday investor, there's no way of investing in swaps directly. However, they can be used in certain levered or inverse ETFs.
A warrant is a contract to purchase stock issued by a company.
Similar to a stock option, a warrant gives the holder the right to purchase a company's stock on a specific date. The two biggest differences between warrants and options are:
- Warrants are sold by a company and not by an individual
- The shares outlined in the warrants have yet to be created
Once the warrant is exercised, the shares are created and dilution happens. Certain brokerages like TD Ameritrade allow us to buy warrants while others like Robinhood do not support warrants.
There are many derivative products out there but only options and futures are directly available to us. Options contracts are usually written for an underlying that is a stock. Understanding options will be an important step in becoming an experienced stock investor. Understanding futures will allow us to invest or speculate with commodities, such as oil prices or coffee bean prices.