People invest their money to make more money. Some people invest with long-term goals, while others want to see profits quickly. Some people have hundreds of thousands of dollars to invest, but many are forced to invest much less. Derivatives appeal to many people who want to see profits quickly, and who don`t have a large lump of money to invest.
The basics of investing in the stock market
If you want to own part of a company such as your local bank or IBM, you go and buy a share in the company. Then if the value of the company goes up or down, the value of your share does as well. You may also get the added profit of a dividend. A dividend is a regular payment from the company to its shareholders to distribute some of the profits. The value of the dividend and its frequency can change depending on the success of the company. The down side of buying stock is that one share can be expensive – you may need to invest $100 or more per share to see $5 in profits.
Definition of financial derivatives
Financial derivatives are investment products based on financial products; their value is derived from the value of what they are based on. One example of a derivative is an option based on a stock that allows you to either buy or sell that stock in the future at a set price. The value of that derivative changes as the underlying asset value changes, but not always in the same direction!
How options work
An option is a contract that lets you buy or sell a set number of shares of a stock at a specific date in the future. You do not need to own the shares to buy one of these contracts. As with all contracts, there must be two parties who agree to it – one person who believes the stock will go up, and another who believes it will go down. For example if stock A is currently selling at $100. Bob thinks that in two months it will go up to $150, but Frank thinks the stock will stay at $100.
Bob buys a contract that allows him to buy 100 shares of stock A at $125. Bob thinks the stock will be worth $150, so he will save $25 per share and make $2,500. Frank also buys a contract, but his allows him to sell 100 shares at $125. Since Frank thinks stock A will be worth $100, if he sells at $125 he will make $25 profit per share. Either one of these contracts cannot happen without the other to balance it out. If everyone wants to sell, the company offering the options will not be able to `cover the spread`. The company offering options charges a fee for the contract to both parties that is considerably lower than buying the actual shares. However, no matter what happens to the stock that company that sold the options makes the profit. For the contract holders, there will only be one winner and loser in varying degrees depending on the value of stock A at the end of the contract.
Benefit 1 – derivatives are cheaper than buying stock
If you believe a stock will go up in value you have two options to take advantage of this. The first is to take a loan from a bank, use the money to buy shares in the company, hold on to them until the stock goes up, sell the stock, pay back the loan, and keep the difference as profit. The problem here is the interest on the loan can quickly eat up your profits if the share price is large. With derivatives you only need a little bit of money because you are not buying the actual shares, just a contract to sell them at a set price on a set date. This means the value of the loan is much smaller, and you can still sell the shares for the same price; this allows you to keep more profits for yourself. The risk with derivatives is that if the stock does not go up like you expect you cannot sell the option to pay off the loan – the value of the option decreases as the deadline approaches. With the stock or asset, you can at least sell it at the current price to pay off some of the loan. This makes options riskier, even though you are committing less of your money.
Benefit 2 – turn around time
You can buy options for any period of time – a day, a week, a month, or more. The longer the period, the more the contract costs per share, but the more potential profit you can make as well. This allows an investor who wants to get their money out in a short period of time to realize their goal.
Benefit 3 – more choice
If you buy a contract to sell 100 shares of stock B at $100 when they are at $50, other people will pay good money for that contract. It is possible to sell a contract to a third party for more than you paid for it in the first place. If the stock price drops, the value of this contract will go up because people can make more profit with it. This means if for some reason you cannot wait to use the contract, you can sell it to someone else and still make a profit.
There are a number of benefits for financial derivatives, such as stock options, but they can come with more risks as well. If you are aware of both, and invest within your means, then derivatives can be a profitable investment.