Derivatives 101
Derivatives are one of the leading forms of financial instruments and play an incredibly powerful and important role in markets all around the world. For some context, the stock market at its peak was a little less than $100 trillion and the derivatives market is over $1 quadrillion. That number is so big it almost doesn’t make sense, but it should give you an idea of just how important derivatives are and why I’ll be giving this little 101 course to help explain them.
Intro
A derivative is a contract between two or more parties whose value is based on some underlying financial asset (like a security) or a set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks. The reason they’re called derivatives is because their value is derived from some other asset or independent metric. The derivative is not the source of value itself, but its value depends on how the underlying asset or metric performs. So derivatives are just investment instruments that allow investors to gain exposure to things without directly buying them. Derivatives are useful because they allow investors to hedge or speculate with leverage, more liquidity, and, as alluded to, the ability to gain exposure to assets like commodities without actually holding them.
Another important thing to note about derivatives is on a common misconception about them and their role in the financial system. Many people argue they serve no real purpose because they don’t provide actual value or encourage business the way investment does. They are seen as purely speculative and many argue derivatives don’t contribute to economic activity or growth. But speculation actually serves an important role whether in traditional investment or derivatives. Speculators help balance out prices by attempting to buy low, sell high or sell high and buy low. The desire to speculate helps encourage the pursuit of fair value. If prices go too far one way or the other, there is more of an incentive to enter the other side of the trade and derivatives play a large role in that process. And aside from helping to pursue fair value, derivatives speculators who buy contracts just to make money will still encourage holders of commodities or shares to stockpile more as a hedge to spot prices rising, which encourages production and can increase the amount of capital available to business. Now this is not to say derivatives are the best financial instrument for stimulating economic growth, but they do serve a purpose and are not devoid of utility.
Alright, with all that out of they way, let’s get into the various forms of derivatives starting with the most well known and work our way down.
Options
Pretty much everyone at this point has at least heard of options, especially after they were popularized in the mainstream by brokers like Robinhood, but I’ll explain them anyway just to cover all my bases.
There are two different kinds of options: a call option and a put option. Call options are the right, but not the obligation, to buy an asset at a specified price referred to as the strike price and put options are the right, but not the obligation, to sell an asset at the strike price. This means regardless of what happens, there is nothing you have to do if you are buying options and all you are ever risking is what you paid to buy the contract(s). Another important note is while you are welcome to hold options until expiration, this is not usually recommended and rarely the case. Generally speaking, you will look to sell your options for a profit before they expire so you don’t actually have to purchase the underlying asset to make your money. Options are contracts to buy assets at certain prices, but exercising an option to actually buy the underlying asset can be very capital intensive because each contract is for a hundred shares. If you want to buy a hundred shares for each contract at your strike price, by all means do it, but you’ll likely want to sell it before expiration to pocket the increased value of the option itself.
Now, one thing that can be a little confusing about options when you’re first introduced to them is you can buy and sell both calls and puts. Buying a call option means you are bullish, but selling one means you are bearish. Conversely, buying a put option means you are bearish, but selling one means you are bullish. This might be confusing so let’s briefly explain each one.
Buying Calls
If you buy a call option, you want price to move higher because your contract will either have intrinsic value or have a higher probability of having intrinsic value at its expiration. Intrinsic value just means your option has real value because it allows you to buy the underlying asset at a discount as your strike price is lower than the current trading price. Let’s say you buy a call option with a strike price of $100. If price trades at $120 before or when that call option expires, it has $20 of intrinsic value per share or $2,000 dollars per contract ($20 x 100). Any trading price higher than your strike price for calls is referred to as ‘in the money,’ which is just a reference to it having intrinsic value. When your strike price is not in the money, it’s either at your strike price, which is called ‘at the money,’ or ‘out of the money,’ which is just the opposite end of in the money. In the case of a call option, out of the money would mean the trading price is lower than your strike price.
Selling Calls
If you sell a call option, you want price to go down or at least trade below the strike price because, if it trades higher, you have to sell those shares to whomever ends up with that contract at expiration. To extend the above example, if you sold a call option with a strike price of $100 and price was trading at $120, you would have to sell those shares for $100 rather than get the market price of $120, meaning you would be losing $20 per share. However, if price traded below the strike price, you would keep all the premium you collected from selling that call option to the original buyer. So, as a seller, you want the call you sell to expire out of the money that way it’s worthless and you profit from the premium you collected. Just keep in mind that selling call options has unlimited risk because prices can, theoretically, go up an infinite amount.
Buying Puts
In the case of buying a put option, it would be the exact same thing as buying a call option but in the opposite direction. You want the underlying asset to trade below your strike price because it allows you to sell the underlying asset for a premium as your strike price is higher than the current trading price. Anything lower than your strike price for puts is in the money and thus has intrinsic value.
Selling Puts
Selling put options would also be exactly the same as selling call options. If you sell a put option, you want price to go up or at least trade above the strike price because, if it trades lower, you have to buy those shares from whomever ends up with that contract at expiration. If you sold a put option with a strike price of $100 and price was trading at $80, you would have to buy those shares for $100 rather than get the market price of $80, meaning you would be losing $20 per share.
So everything with options pretty much revolves around the strike price and the probability of it being in the money at the time of expiration. If price goes up and you only have a day left until expiration, your option value may not increase because the probability is still very low, but the relation of your strike price to the trading price is the most important factor. Depending on what side of the trade you are (buying or selling) you will have different hopes for price being in or out of the money.
You can also get very creative with options through various combinations of buying and selling, expirations, and strike prices. There are far too many strategies to get into, but examples of some these are iron condors where you buy and sell options with different strike prices but the same expiration, which allows you to profit from sideways or a specific range of price action, or straddles where you buy and sell an option at the same price and with the same expiration to try and profit off an increase in volatility regardless of which direction price goes. The point is, there is a lot you can do with options and it’s worth looking into if traditional calls and puts don’t interest you.
Futures
Futures are very similar to options in that they are contractual agreements to buy some underlying asset at a certain price in the future. Also like options, you can buy and sell futures, which functions just like the options do so there’s no need to reexplain that. Futures contracts are available for stocks, indexes, and currencies, but are most commonly understood in the commodity markets as they allow investors and speculators to participate in those markets without purchasing and taking custody of the actual assets, which is very important if you don’t want to deal with holding hundreds of pounds of corn, lumber, copper, or whatever else you’re trying to trade. Futures are extremely popular because they offer cheap leverage that more or less mimics spot trading without much of the hassle. Given these advantages, futures are one of the most liquid markets out there and have garnered a considerable amount of attention from both institutional and retail investors. While all futures contracts mostly function the same, there are different kinds you can buy and sell. Commodity futures are generally standard contracts, but there are also perpetual swaps, both of which I will get into.
Standard Futures Contracts
As mentioned, standard futures are best understood in the context of commodities as they are used by commodity producers to lock in certain prices ahead of time to hedge their risk. For example, if a farmer produces wheat and is worried prices will drop in the future, they can sell a futures contract to lock in the current price for later in the year when they are finally selling their yield. Conversely, the buyer of the futures contract may want to lock in the current price because they believe prices will soar in the coming months. So futures contracts were originally created to hedge against uncertainty and risk on both sides of the trade, especially in commodity markets where money and effort are put into producing things that may fluctuate in price when it's finally time to sell. Now, much like options, standard futures contracts have expirations, however, if you hold a standard contract to expiration, you are obligated to buy the underlying at the specified price, whereas options give you the right to buy the underlying asset. You don’t have to hold the futures contracts until their expiration, but if you do, it’s important to know you have to buy the spot asset at the specified price.
Perpetual Swaps
Perpetual swaps are just like regular futures contracts but with no expiration date, hence the name perpetual. While it may seem better to only have futures contracts without expirations, most commodity producers generally operate around specific delivery dates because they’re growing food or delivering a commodity that is time sensitive, so perpetual swaps don’t offer them the same assurances. That said, perpetual swaps are usually more desirable in markets where delivery is irrelevant, like with indexes or cryptocurrencies. Things like corn and coffee may expire and include a logistically expensive and complicated delivery process, but Nasdaq and Bitcoin never expire and can be settled instantly for little to no extra cost so having a contract with no expiration that offers leverage and mimics the spot price has obvious advantages.
Forwards
Forwards are another form of derivative very similar to futures. The only difference is their customizability to specific terms like price, duration, and delivery. The reason they’re more flexible is because they are OTC or over-the-counter products created and exchanged between private dealers. This may afford them more flexibility, but it also increases counterparty risk as they aren’t run through a centralized clearinghouse or exchange. That said, that doesn’t necessarily mean they are dangerous and often times are just more open ended versions of standard futures contracts that can better cater to the needs of individual parties.
Swaps
This will be the last class of derivatives I get into, and there a number of different types, but all of them are based on the exchange of future cash flows or liabilities like loans or interest payments. Similar to forwards, swaps don’t trade on exchanges or generally reach the hands of retail. They are over-the-counter contracts primarily between businesses or financial institutions that are customized to the needs of both parties. Some of the most popular swaps parties can engage in are currency swaps, debt swaps, total return swaps, interest rate swaps, and credit default swaps. I’ll explain all of these, but I will give the last two, interest rate and credit default swaps, a lot more attention as I believe they are the most important.
Currency Swaps
Currency swaps are used by companies who engage in business abroad to potentially get more favorable interest rates in a local currency than they could get through a bank and also to speculate in and hedge against currency exchange rates. Currencies fluctuate like any other market and so locking in fixed rates rather than the variable market rates for some period down the road can reduce risk or just lead to a profitable move away from that fixed rate if the currency exchange rate moves in your favor.
Debt Swaps
Debt swaps are pretty simple. They’re just the exchange of debt for equity. A company might raise capital by exchanging bonds for stock and they can do that by engaging in a debt swap with a willing buyer.
Total Return Swaps
Total return swaps are actually pretty interesting. If you own an asset such as shares of an index like the S&P500, you can engage in a swap to receive a fixed rate return in exchange for all the potential appreciation and dividends the S&P500 would have over the course of the swap duration. So if you think the S&P is gonna have a weak year, it might be smart to swap your total return for a fixed 10%. Conversely, if you think the S&P is going to have a strong year, you could pay an investor 10% for what could end up being a 20% year. So total return swaps would just be another way to hedge against uncertainty or capitalize on unexpected upside gain.
Interest Rate Swaps
Interest rate swaps aren’t widely discussed or even that well known among the average market participant, but they’re actually the most popular form of derivative. They account for about 60% of all derivatives, which is pretty crazy. While you can use them to speculate like any other investment instrument, their primary use it to hedge against interest rate changes in loans. Loans are offered with either fixed or variable interest rates meaning an interest rate you agree to pay can either be a predictable, unchanging amount or it can fluctuate with the benchmark interest rate like the Fed funds rate or LIBOR, which is the offshore equivalent of the Fed funds rate.
Quite often companies or financial institutions holding variable interest rate loans don’t want to risk paying more than that initial interest rate if rates rise in the future so they will swap their interest rate for a fixed one and transfer that risk to another party. Party A, the party swapping their rate for a fixed one, will now pay that fixed rate to Party B who would now be paying the variable rate. Now, Party B is willing to do this because they are betting that rates will fall in the future and, as a result, they will make money by swapping and capitalizing on that drop in rates. If rates fall, Party A will still be paying the same amount to Party B, but Party B will now be paying a cheaper interest rate. Sometimes eliminating uncertainty is the only real objective for Party A in this scenario as they would rather pay the current rate knowing it won’t go higher than risk paying more. So while Party B getting the better of the deal isn’t always much of a concern, often times these hedges against risk prove to be a really good decision for Party A if rates do end up rising.
Credit Default Swaps
Credit default swaps are the last type of swap and derivative I’ll be discussing and I saved them for last because of their historical significance. Before I get into that historical significance, though, let me explain what they are and how they work.
Credit default swaps are a little similar to options insofar as you pay a premium to capitalize on a potential future price move and all you lose if the trade moves against you is that premium. They’re essentially an insurance policy on loan or credit defaults with an expiration date. The buyer of the swap will make payments to the swap's seller, like a bank, for a yearly premium, which the buyer would have to repurchase every year if they want to keep that insurance. In return, the seller agrees that—in the event that the borrower defaults or experiences another credit event—they will pay the buyer the security's value as well as all interest payments that would have been paid between that time and the maturity date.
Now back to the historical significance. Throughout the great financial crisis (GFC) of 2008 and leading up to it, credit default swaps were how most of the in-the-know investors like Michael Burry, John Paulson, and many others from the popular book and movie ‘The Big Short’ made their killing in the market. At the time, so much of the finical system was over leveraged and at risk of defaulting once the housing boom began to fizzle out, so credit default swaps were how investors hedged or speculated against that risk. The smartest investors saw the system was essentially holding a match over a bed of gasoline and bought a lot of fire insurance. You might ask yourself why anybody would sell this kind of insurance given how unstable the system was, but most investors didn’t think there was anything to worry about. Banks and other financial institutions just wanted to make more money by offering more financial products to clients, so they came up with credit default swaps not realizing they were essentially writing a check for their own demise. They thought they would pocket insurance premium on a low probability event only to later find out buying default insurance on banks and other institutions holding tons of collateralized debt obligations (CDOs) like subprime mortgage-backed securities would end up being the trade of the decade.
So while the original intention behind credit default swaps was to hedge CDOs like mortgage-backed securities, many investors use them to speculate against credit risks of borrowers, which is exactly what those in ‘The Big Short’ did. The investment opportunity with credit default swaps during the GFC was definitely a black swan event and they are by no means guaranteed to be a good investment, but I think it’s important to understand them in this context. That era demonstrated their potential as well as the importance of credit default swaps as insurance on an unhealthy and overheated financial system, and they will probably come back in style in a big way as the world continues to lever up and prepare itself for GFC 2.0. Bearing that in mind, credit default swaps remain one of the best ways to profit or protect yourself from the downside risk of the excessive debt pervasive in markets today—the US certainly being one of those markets.
Conclusion
Even though I covered most of the derivates world, there are plenty I left out and definitely a lot more information on the ones I did include so use this as a stepping stone rather than an exhaustive summary and consider taking a deep dive yourself if it interests you. Derivatives are the most widely used financial instrument because they are easy, cheap, liquid, and, in the case of banks and publicly traded companies, off balance sheet, which is scary and largely why measuring risk in the system during the GFC was so difficult and why it’s still so difficult today. Understanding how derivatives play into the global financial chess board is extremely important if you want to contextualize the broader macro landscape. Given their popularity and role in finance, I’d say it’s worth familiarizing yourself with derivatives a lot more if you want a comprehensive understanding of the markets and the risks therein, but hopefully this article has given you enough to put at least some of the pieces together or send you in the right direction.