A derivative is an advanced form of trading. Investors have historically purchased these short-term contracts, which are collateralized by underlying assets, such as stocks, bonds, commodities, currencies, interest rates, and market indexes, in order to realize rapid profits. However, according to The New York Times website, derivatives are hard to value because "They do not trade openly on public exchanges, and financial service firms disclose few details about them." To successfully invest in derivatives, you must join a brokerage firm to provide professional counseling and broker the deal.
The derivatives market is considered the largest single segment of the financial industry; however, despite its importance, few outsiders fully grasp its size, scope, or how it works, according to a report on The Global Derivatives Market. In efforts to increase transparency and safety, as of July 2010, legislation had begun to regulate the unpredictable nature of derivatives by mandating that they be sold through clearinghouses, which will assume liability, leaving banks who wish to broker derivatives to compete for business based on customer service and price. This shift to will transform derivative trading from a high-risk, high-profit gamble into a more regulated, volume-based business, according to the New York Times website.
The advantages of derivatives to investors include a relatively small, initial investment price, as compared to buying company stock; and, as an investor, you control a large percentage of the derivative, which means that when the value of the company increases, your investment is multiplied exponentially. Derivatives also have a relatively low transaction cost, allow investors to trade on future price expectations and offer contracts that can be tailored to fit the needs of any user, according to The Global Derivatives Market report.
The danger of derivatives, or hedging your bets, is overestimating your future profits. In the event that the market you have invested in goes flat, you stand to lose your initial investment. Investment portfolios often include disclaimers with the warning, "Only invest with risk capital." In other words, don't gamble with what you can't afford to lose. Due to the constantly changing market conditions, which affect the value of the derivative daily and, sometimes, hourly, monitoring of your investment may be necessary to assess the risks. Also, derivatives have different federal tax obligations, which must also be accounted for.
Common types of derivatives include "futures" traded outside of a regular exchange; options, which are the right to buy or sell something at a specified date and price; and swaps, contracts involving an exchange of assets or payments. For example, a derivative option may include the promise to buy so much corn from a farmer at a specific price on a specific date in the future. As an investor, you attain the right to this option by paying a brokerage fee that is non-refundable. In this scenario, as the investor, you hope the price of corn will exceed what you have agreed to pay in advance for it, while the benefit to the farmer is the prospective sale of his corn. However, if the price of corn plummets within the duration of the derivative contract, due to bad weather or a glutted market, for example, as the investor, you have the option to not buy the corn and let the deal expire, but you will have to forfeit your initial investment.
Tracy Stefan began writing professionally in 2007, with work appearing on various websites. She earned a Bachelor of Arts in creative writing and performing arts from the Evergreen State College. Stefan is also a graduate of Dell'Arte.