Understanding Derivatives and How They Work

Are Derivatives Right for Your Trading Strategy?

Most individuals can’t buy a barrel of oil even if they wanted to, and they might have difficulty buying 10,000 shares of a pricey stock. Many traders would like to hedge some of their positions against possible loss. Welcome to the world of derivatives, where it’s possible for individual traders to gain control of everything from foreign currency and precious metals to a stock at some point in the future without purchasing the security.

Put simply, a derivative is a contract – and a financial product – with a price that depends on the value of an underlying instrument or security. The terms “instrument” and “security” are broad, as derivatives can include just about anything that’s traded in global markets. Generally speaking, derivatives can be acquired at a fraction of the cost of the underlying asset.

“For knowledgeable traders, derivatives provide almost endless opportunities to hedge against or capitalize on everything from global economic shifts to a decline in price of an individual stock,” said Brian Bachelier, vice president of active trader strategy for Scottrade. “But derivatives aren’t for everyone because they can expose traders to large losses. They require careful planning and analysis.”

Types of Derivatives

Listed derivatives are traded on organized exchanges or markets, but other derivatives can be traded over-the-counter (OTC) and in private transactions. Here are the 2 most common:

  • Option contracts give traders an opportunity to profit from gains or limit losses at a lower cost than actually buying or selling the underlying security. The most common option offers a buyer the right, but not the obligation, to purchase or sell a stock at some point before its expiration date at a particular price. While there are a variety of reasons for using stock options, there are also many risks that can lead to substantial loss in a portfolio. Option trading is available at Scottrade for approved clients.
  • Futures contracts are used to trade and deliver currencies and commodities (such as precious metals, agricultural products and fuel) for a certain price at a specific point in time. Individual traders typically don’t want to acquire or sell the underlying asset (Do you have a grain bin in your back yard?). Instead, they want to benefit from movement in the price of the underlying asset. Like options, futures are inherently risky, with a downside that can far exceed the original investment.

While futures trading is not available at Scottrade, traders do have access to exchange-traded funds that focus on specific commodities and currencies.

“Options and futures are not for beginners,” Bachelier said. “They can help hedge or enhance your trading positions. But those rewards come at a high risk that each trader must understand.”

Read More: For more advanced financial strategies, learn about the promise and perils of margin trading.

The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.

Options involve risk and are not suitable for all investors. Detailed information on our policies and the risks associated with options can be found in the Scottrade® Options Application and Agreement, Brokerage Account Agreement, by downloading the Characteristics and Risks of Standardized Options and Supplements (PDF) from The Options Clearing Corporation, or by requesting a copy by contacting Scottrade. Supporting documentation for any claims will be supplied upon request. 

Investors should consider the investment objectives, charges, expense, and unique risk profile of an exchange-traded fund (ETF) before investing. A prospectus contains this and other information about the fund and may be obtained online or by contacting Scottrade.  The prospectus should be read carefully before investing.

Commodities and/or futures involve unique risks and are subject to sudden price fluctuations. Please research each investment carefully before investing.

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