One of the most common words thrown around on the news and  the financial markets today is ‘derivative’. Yet, very few exceptions, virtually no one stops to explain to new investors precisely what a derivative is or how one works

The Definition of a Derivative

Derivatives are financial instruments, whose values are derived from the value of another product. The underlying value on which a derivative is based can be an asset (such as equities and bonds), an index (such as a stock market index or FX index), weather conditions, or other items. So if an investor believes that the value of an asset or index is going to rise (or fall) then that investor can trade in the expectation and reality of the price move without ever investing in that asset or index directly

Here’s a great example, not only because it makes the whole concept easy to understand, but because it dates back to the days of Aristotle

There came a time that Thales of Miletus had been told that being a philosopher was not a valued career because it had left him penniless. Amongst his skills was the ability to deduce future weather trends from his observation of the stars. Although it was still the dead of winter, he determined that the following year would produce a good crop of olives. Taking what little money he had, he put down deposits on all the olive oil-presses in Miletus and Chios. This gave him first rights to the pressing services when the following year’s olive harvest came. He did not have to pay much in deposits because he was the only bidder and the press operators were happy to have a bit of money during their off-peak season.

When the time came for the olive harvest there was indeed a large crop. Competition for time on the oil-presses was keen as each oliver grower raced to beat the other growers to market with their crop of olive oil. Of course, Thales of Miletus had all of the time locked up for himself, and he very successfully sold portions of his time at whatever price he cared to ask.

He made a lot of money, and demonstrated that if a philosopher has no money then it is by his own choice!

Even today, especially in the USA, farmers are responsible for a lot of derivatives. They often want to lock in a price for their crops in order to protect their harvest and calculate the profits they’ll make each season. They work with special brokers or companies to sell futures contracts on commodities exchanges. These contracts allow them to sell crops they haven’t yet grown or which are not yet ready for harvest at a predetermined price. The value of these contracts (what the farmer gets paid) depends on what the underlying commodity does over the period of the futures contract. Again, whether a futures contract makes money, loses money, or breaks even depends entirely on the price of the commodity to which it is tied. A coffee futures contract, for instance, “derives” its value from the price of coffee beans

Types of derivative

The four main types of derivatives are forwards, futures, options, and swaps.  A forward is an agreement between two parties to buy or sell an asset at a specified point of time in the future. A future is a contract to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price. An option is a contract between a buyer and a seller that gives the buyer the right—but not the obligation—to buy or to sell a particular asset at a later day at an agreed price. In return for granting the option, the seller collects a payment (the premium) from the buyer. A swap is a contract in which two counterparties agree to exchange one stream of cash flow against another stream, traditionally streams of interest payments.

Derivatives can be used to mitigate the risk of the loss arising from changes in the value of the underlying product. This is known as hedging and is primarily a defensive use of derivatives. On the other hand, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect.  This activity is known – unsurprisingly – as speculation.

One of the key attractions of derivatives is that they allow an investor to ‘lever’ their trade.  So – for example – if an investor believed that a stock currently at 100p per share was going to rise to 120p per share, he might purchase 1,000 of those shares (for £1,000) and make £200 over the period.  However, when the shares are at 100p, the investor might be able to purchase the right to buy shares at 100p in the future for 5p each.  In this manner his £1,000 could buy him 20,000 ‘futures’.  If the share price does indeed move to 120p, these futures would be worth £4,000, making a profit of £3,000.  Clearly, though, if the shares stay at 100p until the time the future expires then the entire £1,000 is lost.  This is what is meant by ‘leverage’. It also reinforces the fact that derivatives are a zero-sum game. in other words , for eavh contract there has to be a winner and a loser

Risk Assessment

Derivatives can either be used to reduce risk assumed elsewhere, or as a risky speculative bet in themselves. They can be complicated, and in most cases it’s possible to lose more than the original investment. As a result, only very experienced investors should consider them. Derivatives products are highly-regulated in the UK,  and private investors will be covered by the Financial Services Compensation Scheme. Please note that this will only cover losses arising from the insolvency of a broker for example, and not losses made through trading. Holding any type of derivative introduces counterparty risk, which is the danger of the company underwriting the derivative running into financial difficulties. This may mean they are unable to honour the contract, potentially resulting in a loss

Taxation treatment

This varies according to the type of derivative. Contracts For Difference (CFD) trading and Spread Betting are both free of UK Stamp Duty, and Spread Betting is also free of capital gains tax. Gains from futures, options and covered warrants are subject to capital gains tax. In all cases tax rules are subject to change, can differ in a jurisdiction other than the UK and depend on your personal circumstances

Be warned – derivatives are for experienced investors only!