The derivatives market is one of the most influential markets in the world, due to its size and interconnectedness with every other market. In the movie The Big Short, derivatives were briefly discussed as one of the underlying catalysts that caused the financial crisis of 2008. The biggest thing about derivatives is that, due to their versatility, they can be applied to almost any financial instrument — from stocks to mortgage bonds — inflating the events in any given market due to their ripple effect. Simultaneously, the term “derivative” will also just about instantly put to sleep anyone who’s not a financier. But how can derivatives be useful for everyday investors, and what’s important (even interesting!) to know about them?
What is a Derivative?
A derivative is any asset whose value is based on the value of something else — in other words, it derives its value from another asset. Called the “underlying” asset, the asset from which a derivative derives its value can be virtually anything, though they’re usually based on things like stocks, bonds, currencies, interest rates, or commodities. Derivatives open the door to a wide range of investment options, and allow investors to take a stake in something like corn or oil, of which they wouldn’t normally buy up physical shares (i.e. barrels of oil or bushels of corn). Derivatives also offer investors a way to hedge their risk, allowing them to take the other side of a trade or investment they already have in the event the original trade doesn’t go their way. For everyday investors, derivatives come in a couple different forms, though institutional trades make up the majority of the market in swaps.
Futures allow two parties to agree to a deal that they will execute at a later point in time regardless of the current conditions at that time. For example, if you thought the price of sugar would go up, you could enter into a futures contract where you agree to pay a set price for the sugar. Someone who thinks the price will go down will take the other side of the contract. If, indeed, the price of sugar does go up, you would execute your contract at the…