Derivatives have a long history. They were created to negotiate commodities, such as wheat, in ancient times. It allowed for the producer to have a safe seller and vice- versa and it allowed for both the producer and buyer to protect them selfs against price fluctuations.
Nowadays, derivatives are a vast market and can be as large as one could imagine. When talking about financial markets, we can separate it into two parts: stocks and bonds; derivatives. The first, although large, can only be as large as the companies “can grow”. It is a very simple way to put it, but when we look at derivatives, they are mostly a contract that underlays on other product. So, to give an example, when a company issues stock, there can be created as many options, futures, forwards, …, as one wants.
Derivatives allow investors to leverage positions and take more risk. This action makes the impact of price fluctuations to be possibly bigger on markets and the economy. When this happens, there’s always two sides of the coin: financial and economic growth; financial and economic contraction. However, if these are viewed as a risk and downsides to derivatives, they also allow investors to hedge and better manage risk, help the market to be more efficient and allow for operational advantages.
Following the 2007/2008 financial crisis, some derivatives became very known, such as CDO’s (Collateralized Debt Obligations), MBS (Mortgage-Backed Securities) and Swaps. These are mostly related to Fixed-Income/Debt and interest rates. However, if the financial crisis left derivatives “frowned upon”, it does not reflect their value and importance.
As seen in the beginning, derivatives are very connected with commodities. The instruments that allowed producers and buyers to trade wheat are called futures and forwards (they are different products). Today, futures, forwards and others are used in any kind of transaction, since equities, fixed-income, interest rates, currencies, among others.
When analysing commodities, their price is often settled with some connection with futures contracts. Commodities “present” price is a reflection of supply and demand. For example, the recent oil negative pricing reflected the shortage of demand. The futures contract that had a due date on 20th April turn to negative ground, however, this did not affect longer-term futures contracts as much, because long term demand and supply reflects other expectations.
Options can also be useful for commodities trading, especially in times of extreme prices. Let’s imagine Silver it an all-time high. Call options could have a high premium and puts a low one. That is, calls may be overpriced and puts underpriced. This is an opportunity for those who detain it to sell it if it starts do devaluate but, if it continues to valorise, they paid a little insurance (premium) on it. In practice, it is not that simple, but it demonstrates a bit of how options are also relevant in commodities markets.
Options are also very used by new traders and traders with low-value portfolios because one can trade, e.g., stocks valued on 300 dollars with 20 dollars contracts. Take note that these examples are not real and do not take into account any valuation model. Let’s imagine that company X is quoted at 100 dollars today (moment 0). Options traders are bullish for the next two months and the most optimistic option for two months later (moment 2) has a strike price of 115 dollars. You believe it will hit higher numbers (maybe you have inside information), so you buy a call option for 120. Many people call you crazy because it will never get that high, so the option price is low. After one month and two weeks (moment 1,5), the stock is valued at 115 dollars, it exceeded all expectations. Now, your option has a higher demand, its price is higher, you sell. Since we are talking on a stock evaluated in 100/120 dollars, your option would cost less than 20 dollars and you don’t need all that money (Graph below).
In conclusion, derivatives play an important role in markets even though they can also be dangerous. Warren Buffet called them “financial weapons of mass destruction”, they can be destructive, but when used right they help investors and traders and have significant importance to balance markets and help their actors.
This article was published in our September 2020 Newsletter
Diogo Marques, BSc in Economics