The global financial market has evolved significantly in recent decades, offering investors various opportunities and tools to diversify their portfolios. With economic volatility and uncertainty becoming commonplace, diversification has become a core strategy to reduce risk and maximize returns.
Among the many options available we also find what we call financial derivatives. These instruments have gained more and more popularity due to their flexibility and the potential to generate substantial profits even in unfavorable market conditions.
This article aims to give you a clear understanding of what derivatives are, how they work, and why they could be valuable to your investment strategy.
We will explore the advantages of using these tools, the main types of derivatives available, and practical examples of their use. We will also give you some useful tips to successfully trade derivatives so that you can make informed decisions and optimize your portfolio effectively.
What are financial derivatives?
Derivative financial instruments are financial contracts whose value depends on the price of an underlying asset, also called the underlying asset. This asset can be of various types such as stocks, bonds, commodities, currencies, or even stock indices.
Derivatives are so called because they “derive” from the value of the underlying asset, that is, their price is closely linked to the evolution of the price of this asset.
The operation of derivatives is based on an agreement between two parties to buy or sell the underlying asset at a future date and at a currently set price. These instruments are often used to speculate on future market movements or to manage risks associated with asset price fluctuations.
The role in the financial market
Financial derivatives have a well-established role in modern financial markets, offering investors and traders various ways to manage risk and take advantage of market opportunities.
One of the main advantages of using derivatives is the possibility to perform hedging operations, i.e. to protect portfolios against price risks.
For example, an investor who owns stocks may use derivatives to protect against a possible decline in the price of those stocks.
In addition, derivatives allow the use of financial leverage, which means that investors can gain greater market exposure with less initial capital. This aspect makes derivatives attractive to traders looking to maximize potential profit, although they also involve higher risks.
The history and evolution of derivatives
The history of financial instruments goes back to ancient times, with the first forms of derivatives being used in agriculture. Farmers and traders used rudimentary futures contracts to hedge future prices for agricultural products.
However, the modern derivatives market began to develop in the 1970s with the creation of financial futures contracts on interest rates and currencies.
Over the years, derivatives have diversified and become sophisticated, becoming complex instruments used by investors, companies, and financial institutions for a variety of purposes. Today, the derivatives market is vast and continues to evolve, adapting to the new needs and trends of the global market.
The advantages of using derivative financial instruments
Financial derivatives are an essential component of modern financial markets, offering investors and companies opportunities to effectively manage risks, diversify portfolios and maximize returns. They allow participation in capital market fluctuations without owning the underlying asset, thereby helping to hedge against uncertainties and speculating on market changes.
- Hedging
One of the main advantages of derivatives is their ability to provide protection against market risks through hedging. Hedging is a strategy used to offset potential losses in a portfolio by opening opposite positions in derivatives.
For example, if you own shares in a company and expect their price to fall, you can purchase a put options contract, which will give you the right to sell the shares at a predetermined price, thus limiting your losses.
Thus, derivatives allow you to protect yourself against unforeseen price fluctuations, ensuring greater stability of your portfolio.
- Financial leverage
Leverage is another significant advantage of derivatives, allowing you to access greater market exposure with little initial capital. In other words, you can control a large position in the market by investing only a fraction of the total value of the contract.
For example, a futures contract allows you to expose yourself to the price movements of an asset without having to actually purchase that asset. This feature makes derivatives attractive to traders looking to maximize potential profit, but be aware that leverage also increases the risk of significant losses should the market move against your position.
- Portfolio diversification
Diversification is a core component of any successful investment strategy, and derivatives can play an important role in this. By using derivatives, you can add different types of exposure to your portfolio, be it commodities, currencies or stock indices, which might otherwise be more difficult or expensive to access directly.
This diversification not only allows you to reduce the specific risk of each asset, but also gives you the opportunity to take advantage of the movements of different markets at the same time, thus balancing the overall performance of the portfolio.
- Reduced costs
Compared to direct investments in the underlying assets, derivatives can be a more cost-effective option. For example, instead of buying shares in a company at full market price, you can opt for an options contract that only requires a lower initial premium.
Derivatives can also involve lower transaction costs and offer the flexibility to close positions before maturity, thereby reducing the costs associated with holding assets long-term.
This cost efficiency makes derivatives an attractive choice for investors looking to optimize their financial resources.
Main types of financial derivatives
Financial derivatives are financial contracts or agreements whose value is derived from the performance of an underlying asset, such as stocks, currencies, commodities or market indices.
They are used by investors to manage their risks, speculate on market developments or gain access to assets without owning them directly. Let’s see the main types of financial derivatives:
- Futures contracts
Futures contracts are standardized agreements between two parties to buy or sell an asset at a specified price at a future date.
These contracts are traded on regulated exchanges such as the CME (Chicago Mercantile Exchange) and are used on a wide range of assets, including commodities (such as oil or wheat), currencies, stock indices and even interest rates.
A basic aspect of futures contracts is that they are standardized, meaning that all contracts have the same specifications regarding the quantity, quality and maturity date of the underlying asset.
This makes futures very liquid and easy to trade. Investors use futures to speculate on price movements of the underlying asset or to hedge against future price fluctuations.
- Options
Options are derivative instruments that give the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a predetermined price (strike price) within a certain period of time or at specific date. Options are used for both speculation and hedging.
Call options are used by investors who anticipate an increase in the price of the underlying asset, as they offer the opportunity to purchase that asset at a lower than market price.
On the other hand, put options are preferred by those who predict a fall in price, as they allow them to sell the asset at a higher price than the market.
Options strategies can range from simple purchases of calls and puts to complex strategies such as spreads and straddles that combine multiple options to take advantage of various market scenarios.
- Swaps
Swaps are contracts whereby two parties exchange financial flows with each other over a certain period of time, according to predetermined terms.
The most common type of swap is the interest rate swap, whereby one party pays a fixed interest rate in exchange for a variable interest rate, or vice versa. These contracts are mainly used to manage risks related to interest rate or currency fluctuations.
Another type of swap is the currency swap, where two parties exchange payments in different currencies to manage currency risk.
Swaps are frequently used by companies and financial institutions to adjust their financial risk profile without changing the underlying asset structure.
- CDS (Credit Default Swaps)
Credit Default Swaps (CDS) are derivatives used to manage credit risk, i.e. the risk that a borrower will not be able to meet its financial obligations.
A CDS works as insurance against default: the buyer pays a periodic premium to the seller, and in return, the seller agrees to cover losses if that borrower defaults.
CDSs are frequently used by financial institutions and investors who want to protect themselves against the risk of default on bonds or other debt issued by companies or governments.
These instruments played an important role in the financial crisis of 2008, being both criticized for amplifying systemic risks and appreciated for the flexibility they offer in managing credit risk.
Financial derivatives: examples
Let’s say you are a farmer who will harvest wheat in six months. You are concerned that the price of wheat may drop by harvest time, affecting your profit. To protect against this risk, you can sell a wheat futures contract at the current market price.
If the price of wheat falls to maturity, the loss from the drop in real price will be offset by the gain from the futures contract sold. Thus, you have managed to protect your income using a futures contract.
On the other hand, if you are a bread producer and anticipate an increase in the price of wheat, you can buy a futures contract. Thus, even if the price of wheat increases until maturity, you will be able to purchase the wheat at the price set in the futures contract, thereby protecting your production costs.
Examples of options
Imagine that you invest in a company that you believe will release an innovative product, which will lead to a significant increase in its share price. To benefit from this potential growth without investing a large amount, you can buy call options on the respective shares.
If the stock price rises above the strike price of your option, you can exercise the option and buy the stock at a lower price than the market, making a profit.
In the opposite scenario, if you anticipate that the price of a stock will fall, you can purchase put options. These give you the right to sell the shares at a fixed price, regardless of the market price drop, thus protecting your investment.
Examples of swaps
A common example of the use of interest rate swaps involves a company that has a floating rate loan and fears that interest rates will rise, which would increase financing costs.
To protect itself, the company can enter into an interest rate swap in which it exchanges its floating interest payments for fixed interest payments from another party. Thus, the company can stabilize its financing costs, even if market interest rates rise.
Another scenario could involve two companies in different countries having loans in their respective local currencies. If both companies anticipate adverse exchange rate fluctuations, they can enter into a currency swap to exchange interest and principal payments into their respective currencies, thus protecting themselves against currency risks.
Case studies
During the 2008 financial crisis, many financial institutions used CDS (Credit Default Swaps) to protect their bond portfolios against issuer default risk. For example, a bank that held bonds issued by a company in financial trouble might purchase a CDS to ensure that if the company defaulted, it would receive compensation from the CDS counterparty. This strategy allowed banks to minimize their losses in the context of a highly volatile market.
Another example of the use of derivatives can be found in the strategy of a large airline that hedged its fuel costs with oil futures contracts. Anticipating an increase in oil prices, the company bought oil futures at a lower price, which allowed it to secure favorable fuel prices even when oil prices rose in the market.
Tips for trading derivatives
Here are some essential tips that will help you trade efficiently and minimize risks when using derivatives:
1. Education and information
The first basic step in trading derivatives is to educate yourself and inform yourself thoroughly.
Before investing real money, you need to fully understand how each type of derivative works, the risks involved, and how these instruments can affect your investment portfolio.
2. Choice of trading platform
Once you feel ready to start trading, it is important to carefully choose the trading platform you will use. The main criteria include security, transaction costs, user-friendly interface and support provided.
Make sure the platform is regulated by reliable financial authorities and offers access to the markets and instruments you want to trade. Also, check if the platform offers technical and fundamental analysis tools that can help you make more informed decisions.
3. Risk management
Risk management is a key element in derivatives trading, as high leverage and market volatility can lead to quick and significant losses. First of all, it is recommended to set clear stop-loss limits for each transaction, so that you can get out of a losing position before it significantly affects your portfolio.
Second, diversification is an effective strategy to reduce overall risk. Avoid investing all of your capital in a single type of derivative or in a single market. Finally, use leverage with caution; while it can amplify profits, leverage can also exponentially increase losses.
4. Market monitoring
Financial markets are influenced by a multitude of economic, political and social factors. That is why it is essential to constantly monitor market movements and be aware of global events that could affect the prices of the derivatives in which you invest.
Use financial news sources, economic calendars and analysis tools to stay informed. By reacting promptly to changes in the market, you will be able to adjust your trading strategies and minimize the risks associated with volatility.
5. Consulting a specialist
Regardless of your level of experience, consulting a specialist can be extremely helpful. An experienced financial consultant can help you define your investment goals, build an appropriate strategy and manage your risks effectively.
Also, attending specialized courses or financial education seminars can give you valuable knowledge and access to networks of professionals in the field. Investing in your financial education is just as important as the investments you make in the market.
