Derivatives are basically contracts for trading in a wide range of financial instruments, including stocks, stock market indexes and currencies.
These let investors hedge against risks, or to speculate with the goal of making large profits. Common derivatives include futures, options, forwards and swaps.
When you invest in a derivative, you’re basically betting that a stock, commodity, bond, interest rate, market index or currency is going to either go up or down.
How they work
Instead of purchasing investments directly, a derivative lets you purchase a contract allowing you to buy or sell the underlying investment at an agreed upon price.
Let’s say you think Generic Corp. is ripe for growth. You can buy stock shares in the company at $100 each. If the stock price rises to $150 over the next few months, you’ve made yourself a tidy $50 per share profit (a 50% return).
If, instead, you choose to buy call options on Generic Corp., you secure a contract that gives you the option to buy shares at $120 each at any time over the next six months. The contract applies regardless of the trading price of the stock.
You have to pay $10 each for the options. If Generic Corp. stock rises to $150, the value of your options to buy stock at $120 will be worth at least $30 each. But since you only had to pony up $10 per share, you’ve actually tripled your profits.
A put option takes the opposite approach by letting you sell the underlying stock several months down the line at today’s fixed price.
You buy put options if you think the price of a stock is likely to drop.
Derivatives are complex financial instruments that can be used to hedge against risk, but they can also increase risk.
The danger: if you fail to correctly predict the movement (up or down) of your underlying asset, the option is worthless and you lose your entire investment.