What you need to know about derivatives

You’ve likely heard of derivatives, but do you know exactly what they are? At their simplest, derivatives are financial contracts between two parties.

A contract’s value is driven by the value of its underlying assets, which can be equities or equity indexes, currencies, commodities and interest rates.

That could sound a lot like something else you may have read about, ETFs, but derivatives are more complex. They lock investors into financial arrangements because futures and forward contracts include agreements to buy or deliver assets at specific dates, while swaps contracts lock people into strict payment schedules.

And unlike normal margin accounts, using derivatives can give people or firms a lot of leverage, says Christopher Foster, co-founder and owner of Blackheath Fund Management.

That’s why “bank-owned brokerage firms don’t like the idea of investors getting firsthand exposure to derivatives,” he adds. Aside from their association with events like the Great Recession, derivatives require “advisors to be more attentive when using and monitoring them. Investing in derivatives isn’t like buying a stock and parking it for 10 years.”

Still, “investors have lots of second-hand exposure to derivatives since a lot of mutual funds and ETFs trade in derivatives, and the structured products they buy from their brokers have a lot of derivatives embedded in them.”

So here’s plain facts about derivatives.

Derivatives basics

Forwards, options and swaps are over-the-counter (OTC), while futures and options on futures are typically exchange-traded, says Carol Derk, leader of the derivatives focus group at BLG.

With OTC derivatives, you enter into a bilateral agreement with a financial institution to set out the terms of the forward option or swap. These derivatives are typically used by large-scale investors rather than individuals.

Meanwhile, exchange-traded futures and options on futures are traded on the Montreal exchange, as well as ICE Futures Canada, located in Winnipeg. Both types of derivatives allow you to buy or sell specific quantities of assets for fixed prices on agreed-upon dates.

Taking a closer look

Farmers have been using derivatives for hundreds of years to help hedge against commodity-price volatility, notes Greg Jones, managing director of global equity derivatives at National Bank.

Today, farmers continue to use derivatives to manage production and obtain predictable prices. This example can help us understand how derivatives stabilize markets and promote liquidity.

During harvest time, says Foster, farmers get ready to sell their products. They’ll need that revenue to pay down mortgages or buy new farm equipment, seed and supplies.

Take wheat farmers, who have a limited window to sell their crops. While they can choose to store products after harvest time, they may not have enough money or space to do so. Also, many farmers need funds immediately to cover harvest costs.

So, “they all tend to sell their wheat in October, November and December,” says Foster. “And that creates substantial price weakness.”

However, derivatives traders and speculators understand these seasonal weakness cycles; they also know prices will bounce back. So they buy the wheat through futures or forward agreements and hold until there’s more demand. In those contracts, they strike sale agreements for future dates at specified quantities and prices.

Thanks to those derivatives agreements, farmers don’t have to sell at lower prices and markets are more efficient.

Derivatives can also help commodities producers hedge. By minimizing risk for farmers, or producers of other commodities, derivatives traders allow production increases at times when low output would otherwise create demand gaps.

That said, farmers entering into derivatives agreements must do their due diligence since they can’t get out of forward agreements. They can only counter forward agreements by entering into second, contrasting agreements with the same party they entered into the initial agreement with.

In contrast, it’s possible to cancel out futures agreements that are traded on exchanges by entering into counter agreements that list the same prices, dates and terms. To do this, a trader can go short or long in stocks or commodities that he’s currently long or short in, respectively.

Who’s in the market?

Though some wealthy individual investors use derivatives, the market is mostly made up of large-scale traders, such as fund companies, and those who are trading on behalf of companies tied to assets like commodities.

For example, fund providers investing in materials markets may use derivatives since it’s expensive to store certain physical commodities, such as wheat and copper. Storage also removes those commodities from trading markets.

However, with “easily storable commodities such as silver and gold, it only costs a fraction of a percent per year to store them,” says Foster. “So companies can actually set up a fund that owns the commodities. In that case, investors are actually buying a percentage of the trust that owns the physical commodities.”

So through derivatives, such as futures contracts, funds can get and provide exposure to these materials.

Larger investment companies can afford compliance and risk management departments that “impose trading limits to make sure market risks don’t impact unit holders,” explains Foster. “They’re able to stipulate that traders can only have positions of certain sizes” and only handle trades up to specific sizes.