How Can Investors Leverage Options And Derivatives For Profits?
The term derivative comes from the Latin “derivare”, which can be roughly translated as “ to derive ”. Financial derivatives are derived from the performance of an underlying asset.
A derivative therefore has no value of its own. Underlying assets can be, for example, individual stocks and stock indices, currency pairs (FX), raw materials (commodities), bonds (fixed income) or interest rates (fixed income).
In contrast to an investment in the underlying asset, you can also bet on falling rates or prices with a derivative. Derivatives on a rising market price are referred to as “long” or “call”, those on a falling price as “short” or “put”.
When purchasing derivatives, a mutual contract is concluded between seller and buyer, which can vary greatly depending on the product. For example, derivatives do not have to participate 1:1 in the underlying.
Other subscription ratios can also be specified. As a result, the securities can reflect fluctuations in the underlying asset disproportionately. The terms of the individual investment products vary depending on the structure.
The structure of a derivative can be very simple (e.g. knock-out certificates) or very complex (CFD) (see below). The fee structure is often difficult for you to understand. The same applies to the contractual conditions.
What Are Options And Derivatives And How Do They Work In Investing?
Derivatives (from Latin “derivare” – “derive”) are financial products whose value is derived from a basic product (“underlying”) – such as stocks, bonds or raw materials.
This allows them to speculate on the future performance of the underlying product without buying it directly. Financial derivatives are often referred to as futures and are very complex forms of investment with high risks for you as an investor.
First of all, different derivatives can be categorized based on the underlyings used[5]. are common:
- Securities (e.g. stocks, bonds)
- Raw materials (e.g. gold, oil, grain)
- Foreign currencies (e.g. euros, dollars)
- Merchandise or products of any kind
- Interest or interest rates or dividends
Financial derivatives can also be distinguished in terms of whether they are unconditional or conditional. With conditional derivatives, there is an obligation to execute the forward transaction. These include fixed transactions (e.g. futures or reverse convertible bonds) that have a fixed due date.
Forward transactions designed as swaps are conditional derivatives. Here several, consecutive fixed transactions are agreed. In the case of unconditional derivatives, executing the forward transaction is merely an option. Therefore they are also called options transactions (e.g. warrants).
How Can Investors Use Options For Hedging And Income Generation?
Institutional investors and financial institutions, as well as commercial and industrial companies, use derivatives to hedge transactions with underlying assets that are in their portfolio. This is called “hedging” – which is where the term “hedge funds” comes from. With a derivative on raw materials, companies protect themselves against price fluctuations.
Investors primarily see the advantage of short-term speculation in derivatives. Because the disproportionate risks of derivatives are often offset by above-average profit opportunities.
Derivatives with high leverage are particularly attractive for speculators. Here investors can achieve high profits by using little capital – but with high risk.
What Are The Strategies For Trading Stock Options And Futures?
Financial derivatives in the narrower sense include, in particular, futures and options. These are futures contracts that are standardized in terms of their due date, underlying value and quantity and are traded on futures exchanges.
Derivatives in the narrower sense that are traded over the counter (OTC) include swaps. Over the counter means trading takes place over the counter between two parties.
Financial derivatives in the broader sense include financial products that contain a derivative component, for example an option. These include certificates (e.g. discount or bonus certificates) and leverage products (e.g. CFDs, knock-outs).
These investments are also referred to as structured products. An issuer, usually a bank, issues it as a securitized security in the form of a bond for investment or trading.
In terms of their term, their repayment profile or their trading size, certificates and leverage products – unlike standardized futures and options – can have a very diverse design. In addition, trading can take place both on an exchange and over-the-counter via the issuer. Common derivatives in this segment are warrants and certificates.
What Risks And Margin Requirements Are Associated With Derivatives?
Derivatives can be very risky financial products with these factors:
- Complexity: Derivatives are very complex and difficult to understand. Over- the-counter trading in particular is often non-transparent.
- Leverage: Leverage is a key feature of many derivatives. With a relatively small investment of capital, you as an investor can control a large position. While you can maximize profits, leverage significantly increases the risk of losses.
- Obligation to make additional contributions: Certain derivatives may entail an obligation to make additional contributions for you as an investor. This means that in case of a loss you will have to deposit additional capital. However, such an obligation to make additional contributions is prohibited, among other things, for futures. You should pay attention to the specific contract structure before you invest.
In addition to the risks mentioned, there is criticism of financial products from a social perspective. The main criticism is that derivatives are often used by speculators who do not necessarily have an interest in the underlying asset.
Critics argue that speculation on commodity futures exchanges can distort prices or lead to significant price increases. They hold derivatives partly responsible for food crises and famines in developing countries. To what extent this is actually true is difficult to say.
Are There Advanced Derivative Strategies For Experienced Investors?
Since even small price movements of the underlying asset in the undesired direction lead to high losses or even a total loss, investors should define a stop price before purchasing a leveraged product.
True to the motto: This far and no further. You should also never try to make up for a loss by buying something else seemingly cheaply. In most cases this goes badly wrong.
Professional level investors often manage investment projects with large amounts of assets, and this method is their biggest source of income. Of course, there are advanced derivative strategies for this type of investors.
The most common among advanced derivative strategies is the creation of complex positions with options, futures and other asset classes and the development of more successful risk management.
The common advice of experts to investors to diversify their investment portfolios is valid in the context of derivative strategies, as in every investment model.
See you in the next post,
Anil UZUN