A derivative financial product is an asset that is based on another underlying asset. In principle, they are born to simplify the investment in some underlying assets. For example, if you want to invest in the Nasdaq 100 index, instead of buying shares of each of the companies in the index, for which you would need to calculate the proportion each company represented in the Nasdaq, you can buy, for example, an ETF.
However, in practice, derivatives are categorised under the financial complex instruments class. This is because a derivative does not have value per se. Its value depends on the underlying asset. Moreover, the value can be affected by the performance of the derivative’s creator. One thing is to write on paper that this derivative will replicate that index and another is achieving it, which is very different. As an investor, you need to forecast the underlying asset’s price evolution and the performance of the product replicating that evolution. Thus, they are much more complex than a simple stock.
The most common derivatives are:
- ETFs
- Futures contracts
- Options
- Swaps
- Warrants
Types of derivatives
There can be many categorizations, but the main one refers to whether the derivative is an option or not.
An option means that you have the right to sell or buy, but you do not have the obligation to do it. If it is not an option, it means that the derivative works as if you had bought the underlying asset. In other words, you have something that you will need to sell sometime in the future.
When investing into derivatives that are options, you need to understand how leverage works in order to not assume more risk than you would like.
Some tips about extra-precautions to take before investing in derivatives
When investing in derivatives, it is important to check how well they track the performance of the underlying asset. It is very disappointing to see that the asset proves to be a good investment and when checking the derivative’s evolution you see that you have lost most of the rentability due to its bad performance.
In this regard, you also need to take into account the management fee many derivatives have. For that, you should have a small report that informs about the derivative.
In addition to the risk of a bad track of the underlying asset, you have to check if the derivative is a debt that a company has to pay to you. That would be the case, for example, with ETNs. In such case, bankruptcy of the institution will make you lose money even when your forecast was right.
If you do not know how to check or look for these aspects, it is probable that you do not have enough education to invest in derivatives. Keep getting educated, and your time will come.
Please keep in mind that this article is only for informative purposes. It may be wrong and does not pretend to be financial advice. Ask for professional help if you have doubts.