Friday, August 12, 2011

Different Types of Derivatives and What They Mean

Mutual funds, stocks and bonds are investments types that most investors have at least a basic familiarity with. Although derivatives aren't purely part of the alternative investment types, they are generally much less understood. Perhaps for good reason. Derivatives get their name based on the fact that they are derived from other investments. The value of a derivative varies based on the value of something else like an interest or exchange rate for example.

Derivative types - Option and Forward-based

There are essentially two distinct classes of derivatives. There are actually only two main types of derivatives: option-based and forward-based. Both can be exchanged privately or a recognized exchange. This is very similar to other types of investments which operate in a similar fashion.

Type 1 - Option Based Derivatives
The word "option" specifically gives an investor the opportunity at some type of purchase for a set price in a set period of time but not the obligation. That investor pays a fee or "premium" to obtain this option contract but a transaction is not at all required. Option-based derivatives represent the right, but not the obligation, to engage in a transaction within a set period of time. Put options are one such example which is an option to sell a security at a certain price for a given period of time. In a way, a put option kind of functions like a short term insurance policy.

Type 2 - Forward-Based Derivatives 

Forwards are typically different in that the transaction represents a future obligation, as opposed to an option, to complete the transaction for a set price in the near future. There is typically no up front cost or premium to enter into a forward-based derivative contract. When a forward contract is traded on a recognized exchange, it is referred to as a “futures contract” or “futures” for short. Futures and options are very common on these types of exchanges. Examples of futures include commodities, interest rates, currencies, and stock market indices. 

Derivatives Basics

The main reason investors have such a high interest in derivatives is simple. While they have extremely high risk transactions, high risk often equate to incredibly high profit potentials. Obviously, before you make any sort of high risk transaction, you obviously want to deal with a highly trained professional. Strategies can often be complex and require understanding of multiple fields.  However, given the enormous potential for returns, there is no question the derivatives will continue to be something which entices investors towards the big profits.

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