Finance

What’s this? Why are they so risky?

Derivatives sound tempting – because you can make high profits with them very quickly. But at a high price. We explain to you what derivatives are exactly and how they work.

Derivatives are almost as old as trading itself. Nevertheless, very few people know exactly how these financial products work. Originally they were supposed to hedge the risks of trading transactions, but today they are mainly used for speculation.

Exactly how this works, what types of derivatives there are and whether an investment is also worthwhile for private investors – you will find the answers in our overview.

What is a derivative?

Derivatives are special financial products whose prices are derived from other systems. This means that the price of an equity derivative derives its price from stocks, that of a bond derivative is based on the value of the bonds.

The name already indicates this mechanism. “Derivare” comes from Latin and means exactly that: to derive. Other names for derivatives are Futures or Futures contracts.

The investments on which the derivatives are based are called Underlyings, Basic products or in English Underlyings. In addition to stocks and bonds, derivatives can also be derived from raw materials, currencies, indices or interest rates.

Basically, that means you make a bet with derivatives. Because you are not investing directly in stocks, bonds and other investments, you are speculating how their value will develop in the future. You do not have any of these underlyings, but still have a share in their development.

How do derivatives work?

Because derivatives are a bet how the underlying assets develop, you can – unlike a direct investment in the underlying asset – also bet on falling courses or prices. These derivatives are known as “short”, “put” or “bear”. On the other hand, speculate with your derivatives on rising prices or prices “long”, “call” or “bull”.

You can use derivatives both to speculate and to hedge a risk. However, the latter rarely occurs because there are other, cheaper instruments available.

  • Speculation with derivatives: Let’s assume you are assuming the price of oil will rise and want to profit from it without investing your money directly in a commodity fund with oil. Then you can, for example, buy a derivative on the oil price that maps it one to one. Let’s say that derivative costs $ 5 and the barrel is $ 50. If the price of oil then rises by 10 percent, the value of the derivative rises in the same range, so that it is worth $ 5.50. But you could also choose a derivative that shows the price development of the underlying asset disproportionately – for example, one in ten. In our example, your derivative would not be worth $ 5.50, but $ 10. In this case one speaks of a “leverage product”.
  • Risk hedging with derivatives: Financial institutions or companies also use derivatives to hedge against currency, exchange rate or price fluctuations. In technical language, this is called hedging or hedge business. Here’s how it works: Let’s say a cotton producer wants to make sure the price of their product doesn’t drop below $ 0.50 per pound by the end of the year. Then he can buy a derivative that guarantees him exactly this price. On the other hand, a textile company could want cotton to cost a maximum of US $ 0.50 per pound at the end of the year and acquire a corresponding derivative. If the price of cotton falls below $ 0.50 per pound, the cotton producer benefits because he can sell cotton at a higher price. If, on the other hand, the price rises, the textile company is happy because it can get cotton cheaper.

What types of derivatives are there?

There are a variety of derivatives and new products are constantly being added. The main types include:

  • Certificates: There are many different types, such as index certificates, bonus certificates or reverse convertible bonds. What they all have in common is that they reflect the development of an underlying asset.
  • Futures: Here you secure certain conditions (e.g. price, quantity, time) for an underlying asset that you want to trade in the future. You also undertake to actually carry out this trade.
  • Options / warrants: There is no such obligation here. This means that if you buy an option, you can use the conditions secured with it, if they are ultimately more favorable for you than the conditions on the market, but you do not have to. If the market offers better conditions, trade on them instead and let the option expire. However, a premium is always due for this product, regardless of whether you use the option or not.
  • Swaps: Here you swap liabilities in order to get cheap outside capital. For example, if a company wants to free itself from the risk that the interest on a loan could rise, it can swap the variable interest rate on the loan for a fixed interest rate.
  • CFDs: CDF stands for “Contract for Difference”, in English contract for difference or contract of difference. With such a derivative, you conclude a contract on the price difference of the underlying asset. If you speculate, for example, that the price of the base value will rise, you will receive the difference between the price at the time the contract is signed and the price at the end of the contract – provided that your assumption about a rising price has been made. Otherwise you will have to pay the difference to the starting price if the price has fallen.

Derivatives can be both on the stock exchange as well as traded over the counter become. The latter is called OTC derivatives, where OTC for “Over the counter” stands, in German: over the switch. The business with OTCs can be processed faster and you save the exchange fees. However, OTC derivatives are often even more risky than their exchange-traded counterparts because they are not subject to the usual control mechanisms. In addition, products are difficult to compare because the market is not transparent.

In addition, one differentiates between conditional and unconditional futures. Conditional forwards, for example futures and swaps, because you are obliged to execute the trade. An unconditional forward deal, on the other hand, exists in the case of options that you can use but do not have to.

Why are derivatives being criticized?

Since derivatives are products that are derived from other products, they lead to the number of financial instruments and also the volume of purchases and sales inflates – and that detached from the real economy. To put it simply, more bets are made and risks are hedged more often than transactions are actually made.

That, in turn, suggests that many speculators are on the way, for example artificially drive up the prices of raw materials. Ultimately, it may be so high that entire countries can no longer afford vital raw materials such as wheat or rice.

Derivatives also hold up for investors high risks. On the one hand, this is because they are very complex and therefore difficult to understand – also in terms of costs. On the other hand, you can suffer a total loss with derivatives. Consumer advocates therefore do not consider these products to be a serious investment – but an alternative to the casino.

Security-conscious private investors should therefore better resort to other investment options – for example one ETF savings plan or others Funds.

Related Articles

Back to top button