Can you explain what a derivative is

What are derivatives? Simply explained | Definition & examples

Derivatives sound tempting - because you can make high profits with them very quickly. But at a high price. We explain to you what derivatives are exactly and how they work.

Derivatives are almost as old as trading itself. Even so, very few people know exactly how these financial products work. Originally they were supposed to hedge the risks of trading transactions, but today they are mainly used for speculation.

Exactly how this works, what types of derivatives there are and whether an investment is also worthwhile for private investors - you will find the answers in our overview.

What is a derivative simply explained?

Derivatives are special financial products whose prices are derived from other systems. In other words, the price of an equity derivative derives its price from stocks, that of a bond derivative derives from the value of bonds.

The name already indicates this mechanism. "Derivare" comes from Latin and means exactly that: to derive. Other names for derivatives are Futures or Futures contracts.

The investments on which the derivatives are based are called Underlyings, Basic products or in English Underlyings. In addition to securities such as stocks and bonds, derivatives can also be derived from raw materials, currencies, indices or interest rates.

In practice this means that you are using derivatives Bets on the performance of the basic products can enter. Because you are not investing directly in stocks, bonds and other investments, you are speculating how their value will develop in the future. You do not have any of these underlyings, but you still have a share in their development.

How do derivatives work?

Because derivatives are, so to speak, a bet on how the underlying assets develop, you can - unlike a direct investment in the underlying asset - also bet on falling courses or prices. These derivatives are known as "short", "put" or "bear". On the other hand, speculate with your derivatives on rising prices or prices "long", "call" or "bull".

You can use derivatives both to speculate and to hedge a risk. However, the latter rarely occurs because there are other, cheaper instruments available.

  • Speculation with Derivatives: Let's assume you are assuming the price of oil will rise and would like to profit from it without investing your money directly in a commodity fund with oil. Then you can, for example, buy a derivative on the oil price that represents it one-to-one. Let's say this derivative costs $ 5 and the barrel is $ 50. If the price of oil then rises by 10 percent, the value of the derivative also rises in the same range, so that it is worth $ 5.50. But you could also choose a derivative that shows the price development of the underlying asset disproportionately - for example, one in ten. In our example, your derivative would not be worth $ 5.50, but $ 10 (10 percent * 10 = 100 percent). In this case one speaks of a "leverage product".
  • Risk hedging with derivatives: Financial institutions or companies also use derivatives to hedge against currency, exchange rate or price fluctuations. In technical jargon, this is called hedging or hedge business. The hedge works like this: Let's say a producer of cotton wants to make sure that the price of his product does not fall below $ 0.50 per pound by the end of the year. Then he can buy a derivative that guarantees him exactly this price. Conversely, a textile company could want cotton to cost a maximum of US $ 0.50 per pound at the end of the year and buy a corresponding derivative. If the price of cotton falls below $ 0.50 per pound, the cotton producer benefits because he can sell cotton at a higher price. If, on the other hand, the price rises, the textile company is happy because it gets cheaper cotton.

What types of derivatives are there?

There are a variety of derivatives and new products are being added all the time. The most important types include:

  • Certificates: There are many different types, such as index certificates, bonus certificates, knock-out certificates, discount certificates or factor certificates. What they all have in common is that they reflect the development of an underlying asset. Find out who certificates are worthwhile here.
  • Futures: Here you secure certain conditions (for example price, quantity, time) for an underlying asset that you want to trade in the future. You also undertake to actually carry out this trade.
  • Options / warrants: In contrast to a future, there is no such obligation here. This means that when you buy an option or a warrant, you can use the conditions secured with it, if they are ultimately more favorable for you than the conditions on the market - but you do not have to. If the market gives better conditions, trade on them instead and let the option expire. However, a premium is always due for this product, regardless of whether you use the option or not.
  • Swaps: Here you swap liabilities in order to get cheap outside capital. For example, if a company wants to free itself from the risk that the interest on a loan could rise, it can swap the variable interest rate on the loan for a fixed interest rate.
  • CFDs:CFD stands for "Contract for Difference". With such a derivative, you conclude a contract on the price difference of the underlying asset. For example, if you expect the price of the base value to rise, you will be paid the difference between the price at the time the contract was concluded and the price at the end of the contract - provided that your assumption about a rising price was correct. Otherwise, you will have to pay the difference to the starting price when the price has fallen.

Derivatives can be both on the stock exchange as well as traded over the counter become. The latter is called OTC derivatives, where OTC for "Over the counter" stands, in German: over the switch.

The business with OTCs can be processed faster, and you save the exchange fees. However, OTC derivatives are often even more risky than their exchange-traded counterparts because they are not subject to the usual control mechanisms. In addition, the products are more difficult to compare because the market is not transparent.

In addition, a distinction is made between conditional and unconditional futures. Conditional forwards are for example futures and swaps because you are obliged to execute the trade. An unconditional forward deal, on the other hand, exists in the case of options that you can use but do not have to.

Why are derivatives being criticized?

Since derivatives are financial products that are derived from other investment products, they lead to the number of financial instruments and also the volume of purchases and sales inflates - and that detached from the real economy. Specifically, critics complain that more bets are made and risks are hedged more often than business is actually done.

That in turn suggests that many speculators are on the way, for example artificially drive up the prices of raw materials, possibly so high that entire countries can no longer afford vital raw materials such as wheat or rice.

Derivatives also hold up for investors high risks. On the one hand, this is due to the fact that they are very complex and therefore difficult to understand - also in terms of costs. On the other hand, with some derivatives you can suffer a total loss more quickly than with the normal purchase of shares.

Consumer advocates therefore do not consider derivatives to be a particularly serious investment - but rather an alternative to the casino. Especially beginners and security-conscious private investors should therefore better resort to other investment options - such as an ETF savings plan or other funds.