This article explains what derivative securities are and how they are used by investors, diving into the specifics of the five most common types of derivative contracts and the differences between them.
Derivatives are financial instruments whose value is derived from one or more underlying assets or securities (e.g., a stock, bond, currency, or index).
What are derivatives (and why are they called that)?
A derivative is a contract that derives its value and risk from a particular security (like a stock or commodity)—hence the name derivative.
Derivatives are sometimes called secondary securities because they only exist as a result of primary securities like stocks, bonds, and commodities. Some derivatives may also derive their value from interest rates, currencies, or entire indexes of securities.
Options contracts are one popular type of derivative security. They grant their owners the right to purchase or sell a security (usually a stock) for a specific price on or before a specific expiration date. Because the value of an options contract depends in part on the value of the underlying stock or security, an options contract is considered a derivative (or secondary) security.
Characteristics of derivatives
Different types of derivatives have different features and characteristics, but there are a few things they all have in common:
- They derive their value (and risk) from the price movement of an underlying asset or group of assets.
- They are agreements (contracts) between two or more parties.
- They expire or settle on a particular date.
5 common types of derivative securities
There are five main types of derivative financial instruments—options, futures, forwards, swaps, and warrants.
1. Options
Options are contracts that grant their owners the right (but not the obligation) to purchase or sell a specific security for a specific strike price on or before a specific expiration date. Put options give their owners the right to sell something, and call options give their owners the right to buy something.
The price an option buyer pays an option seller (sometimes referred to as an option writer) for an options contract is called a premium. An option’s premium depends on its strike price, the amount of time remaining until its expiry, and the volatility of the underlying asset.
Standardized options contracts can be traded on public exchanges like the NYSE and Nasdaq, or they can be traded between private parties on the over-the-counter (OTC) market. Different investors use options for different purposes, but they are most often used to hedge positions or speculate on future price movements of various securities.
3. Futures
A futures contract obligates its buyer to purchase—and its seller to sell—a specific quantity of a particular security (often a commodity like corn or crude oil) at a predetermined price (usually the current market value of the security) on a particular date in the future. In other words, futures contracts allow buyers and sellers to “lock in” the current price of an asset for a future date.
If an investor speculates that oil prices will rise over the next six months, they might buy a futures contract that obligates them to purchase X barrels of crude at today’s price six months from now. If the price of oil does go up, they can either sell the contract to another buyer for a higher premium or wait until the contract’s expiration and take possession of the barrels at the now-discounted price.
Like options, futures are typically used to hedge positions or speculate on price movement. While futures most often deal with commodities, contracts also exist for stock indexes, individual stocks, currencies, and bonds. Futures have standardized terms and trade on public exchanges.
2. Forwards
Forward contracts are similar to futures in that they are agreements between two parties to buy/sell a specific asset for a predetermined price on a specific date. They differ from futures, however, in that they are not standardized—the terms of each contract are negotiated and determined by the parties involved. For this reason, they are traded only on the over-the-counter market and not on public exchanges.
Additionally, while futures contracts settle daily and can be bought and resold by retail traders until expiration without taking delivery of the actual commodity, forward contracts only settle upon delivery. In other words, a forward contract buyer must actually take delivery of the asset in question (e.g., 10,000 pounds of corn). For this reason, forward contracts are popular with actual producers and users of physical assets.
4. Swaps
A swap is a customized derivative contract through which two parties agree to exchange the payments or cash flows from two assets at a set frequency for an agreed-upon period of time. These contracts are negotiated privately—usually between businesses and/or institutional investors as opposed to individuals—via the over-the-counter market.
One payment or cash flow is typically fixed, while the other varies depending on some factor—examples include interest rates, currency exchange rates, stock index values, and commodity prices. Fixed-vs-variable interest rate swaps and currency swaps are among the most popular types of swap contracts.
5. Warrants
Warrants are somewhat similar to options in that they confer the right to buy or sell a security like a stock on or before a specified expiration date at a particular strike price. Unlike options contracts, however, stock warrants are issued by the company itself, and they represent new shares, meaning that if an investor exercises one, the shares they buy from the company add to that company's total outstanding shares, thus diluting the value of all existing shares.
The terms of warrants also tend to be far longer than those of traditional options, with many expiring five or even ten years after being issued. Additionally, warrants typically trade over the counter rather than on public exchanges because the contracts are customized rather than standardized.
Similarities and differences between different derivative securities
| Options | Futures | Forwards | Swaps | Warrants | |
|---|---|---|---|---|---|
Option or obligation: | Option | Obligation | Obligation | Obligation | Option |
Terms: | Standardized or custom | Standardized | Custom | Custom | Custom |
Traded on: | Public Exchanges and OTC | Public Exchanges | OTC | OTC | OTC |
Why do investors trade derivatives?
Businesses, institutions, and investors use derivative securities for various purposes, but hedging and speculation are probably the most common. Here are a few examples of how derivatives might be used in the real world:
- A plant that uses crude oil in the production of plastics might purchase a forward contract to lock in the current price per barrel to ensure that their supply won’t be disrupted if oil later jumps to a price that is too high for their production to be profitable.
- An investor who believes a certain technology company’s stock will drop within the next six months because a company’s new management team is likely to misuse its cash flows might write (sell) call options with a strike price equal to the tech company's current market price that expire in six months. If the company’s stock price does drop by then, the contracts will expire worthless, and the writer (seller) will pocket the contracts’ premiums.
- A farming company that is unsure about future demand for corn might sell a futures contract for 50,000 ears of corn that expires in eight months to ensure that it will be able to sell its produce at its current value even if its value drops in the future due to decreased demand.
- An investor who is bullish on alternative energy might buy call options for a solar power installation company with a strike price that is significantly higher than the company’s current spot price (market value). If the company’s stock price rises to or above this strike price, the investor can then resell the contracts for a higher premium or exercise them in order to take ownership of the underlying shares.
Where are derivatives traded?
Where a particular type of derivative is traded depends on its nature. Some derivative securities are traded both on public exchanges and privately on the over-the-counter market, while others only trade on one or the other.
For example, standardized options are traded on public exchanges, while custom options are traded over the counter. Futures, which are standardized, are traded on public exchanges, while forwards, which have custom terms, are traded privately OTC. Swaps and warrants are also traded OTC.
What does Warren Buffett think about derivatives?
Famed investor Warren Buffett has described derivative securities as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
While the derivatives market is more regulated than it once was, and Buffett himself occasionally trades derivatives through his company, Berkshire Hathaway, he nevertheless referred to the asset class as “a potential time bomb in the system if you were to get a discontinuity or severe market stress" in 2016.
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