A short introduction to derivatives


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Joanne SnelMarch 24, 2022
Trading


Derivatives are relevant in just about every field: mathematics, linguistics, chemistry, law — need we go on? It turns out, derivatives also come up in finance. Not just for optimisation purposes, but as a financial instrument that you can trade. 🤯 Derivatives leave a lot of people scratching their heads. And we get it. After all, a derivative doesn’t have any intrinsic value, so how can it be worth anything? In this article, we’d like to demystify derivatives — we’ll discuss who’s using them, what they are and how they can be valued. Let’s get to it!

Title Card for "A short introduction to derivatives"

There’s a big difference between ‘investing’ and ‘trading’. The end goal — taking profit from the movements of the stock market — is the same. Instead, the difference lies in the way to get there. Investing takes a long-term approach to the markets. Usually, if you’re contributing to a retirement fund, general savings-plan or employing a buy-and-hold strategy, you’re investing. On the other hand, if you’re looking to profit off of the hourly, daily, weekly or monthly movements of the stock market, you’re probably (day)trading. The latter is usually more risky, but at the same time might deliver higher returns. No matter which approach you choose, it pays off to be informed about stock market jargon. 

🎾 The players

In reality, retail investors (non-professional individuals participating in the stock market) make up less than a quarter of the (US) stock market activity. So, who else is playing?

🤑 The funds 

A ‘fund’ is money collected to serve a particular purpose — there are a few entities that pool money, manage said capital and generate wealth. You’ve heard of ETFs, or exchange-traded funds, which are diversified baskets of goods, such as stocks or bonds. Perhaps an ETF doesn’t strike you as a traditional ‘fund’, but ETFs can be seen as a predefined portfolio of individual stocks/bonds, which remove the guesswork out of investing. Traders can purchase them on an exchange, and, just like stocks, ETFs have constantly fluctuating prices. 

Mutual funds (SICAV in Europe) are comparable to ETFs, but cannot be traded on the exchange as they are usually directly purchased from the issuer. Mutual funds can be actively managed or passively managed, the latter tracks a benchmark index such as the S&P500 with the goal of matching returns, you might know them as index funds. On the other hand, an actively managed fund has the goal to beat the performance of a particular index. Fund managers buy and sell investments with the intention of earning a profit for themselves and their clients. 

Perhaps you’ve heard of Bridgewater Associates, Renaissance Technologies or Two Sigma Investments? These are all large American hedge funds. A hedge fund can be compared to a mutual fund, but think bigger (and riskier). Hedge funds are contributed to by wealthy individuals. In return, there also exists an expectation of higher yields. In order to achieve this, fund managers often invest in non-traditional and risky assets, such as real estate, fine art and derivatives (😉). Often, hedge funds use leveraged methods: they borrow money to multiply potential returns. High risk, but also high reward. 

So, can you as a retail trader get a taste of what these hedge funds are achieving? It’s unlikely (unless you’re secretly a millionaire), but you can get informed about some of their trading strategies, like investing in the derivative market. 

💰 Just stocks? Nope.

In the lemon.markets context, we’re usually just talking about stocks — but, theoretically, you could trade with just about anything that’s used as a store of value. Think metals, baseball cards, the promise of concert tickets, virtual art...

In this article, we’ll focus on derivatives. As the name suggests, a derivative is a contract that’s based upon (or derivedfrom) an underlying asset. Derivatives might be bought for the same reasons as stocks (profit), but traders also enter derivative contracts as a way to mitigate risk. How? Imagine you’re invested in agriculture, for example, wheat. The stock price is contingent on several factors, probably one of those being the weather (too little or too much rain = poor crop yield). What if you bet against the rain? You can trade in weather derivatives, which work like insurance against weather-related losses. You can enter a contract: if there’s no heavy rain (or no rain at all) before the contract expires, you’ll pay a premium (which you can afford because business is booming) and in the event of adverse weather, you’ll receive compensation (agreed upon prior to signing). Win-win. 

The ‘underlying asset’ can be just about anything, including the aforementioned weather! This example might seem a little far-fetched but derivatives also exist for more common financial assets, like stocks, bonds or currencies. 

So, what’s a derivative?

There are four main types of derivatives: futuresforwardsoptions (calls and puts) and swaps. We won’t cover the differences in this article, but for those interested, you can read more here. In short, a derivative is a contract that speculates on the price of the underlying in the future. This future price is called the strike price and derivatives always have an expiry date. For example, imagine a trader buys a call option contract for 100 shares of stock X with a strike price of €25 for €150. On the expiration date, stock X is trading at €35, which makes being able to buy 100 shares at €25 extremely desirable. Because the trader signed the options contract in the past, they can now exercise it and profit off of this €10 difference per share, that’s €1000 — €150 = €850 profit if they immediately sell upon exercising the option.

Note: you don’t need to necessarily exercise the options you buy, you can also trade the option contract itself — it might help to think of this as being two levels deep. You’re not actually trading stock X, but rather a bet on the future price of stock X.

🎯 Risky business

Derivatives are notoriously hard to value because they are based on the value of another asset. Consequently, there’s also a large amount of vocabulary that exists to explain the price sensitivity and risk that’s associated with derivatives (specifically options) and they’re known as ‘the Greeks’. 

🕊 The Greeks

The most commonly used Greeks are deltatheta, gamma and vega, which are numbers/values which are informative about the price or risk of an option. If you’re into mathematics, you’ll know that delta (Δ) represents change. In options, delta is the rate of change between an option’s price and a 1 unit (e.g. €1) change in the underlying asset’s price. Theta(Θ) is the rate of change between an option’s price and a unit of time (e.g. 1 day). Gamma (Γ) is the rate of change between an option’s delta and a 1 unit change in the underlying asset price — think: the rate of change of the rate of change. Vega (ν) is the rate of change between an option’s value and a 1% change in implied volatility. 

Combined, these primary Greeks can be used to price options according to, for example, the Black-Scholes model. This differential equation is widely accepted as a way to fairly valuate options. 

In the lemon.markets context, you won’t be trading derivatives (yet), but it’s good to know what other players are up to (or maybe future you). 😎 Trading is a continuous learning process and we hope that with this article, we were able to make derivatives a bit less of a mystery. 

If you haven’t signed up to lemon.markets yet, you can do that here. We’d be happy to have you on board. Any questions? Join our Slack community.

Joanne 🍋

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