5 Popular Derivatives and How They Work

Derivatives offer investors a powerful way to participate in the price action of an underlying security. Investors who trade in these financial instruments seek to transfer certain risks associated with the underlying security to another party. Let's look at five derivative contracts and see how they might enhance your annual returns.

1. Options

Options allow investors to hedge risk or to speculate by taking additional risk. Buying a call or put option obtains the right but not the obligation to buy (call options) or to sell (put options) shares or futures contracts at a set price before or on an expiration date. They are traded on exchanges and centrally cleared, providing liquidity and transparency, two critical factors when taking derivatives exposure.

Primary factors that determine the value of an option:

• Time premium that decays as the option approaches expiration
• Intrinsic value that varies with the price of the underlying security
• Volatility of the stock or contract

Time premium decays exponentially as the option approaches the expiration date, eventually becoming worthless. The intrinsic value indicates whether an option is in or out of the money. When a security rises, the intrinsic value of an in-the-money call option will rise as well.

Intrinsic value gives option holders more leverage than owning the underlying asset. The premium a buyer must pay to own the option increases as volatility rises. In turn, higher volatility provides the option seller with increased income through a higher premium collection.

Option investors have a number of strategies they can utilize, depending on risk tolerance and expected return. An option buyer risks the premium they paid to acquire the option but is not subject to the risk of an adverse move in the underlying asset.

Alternatively, an option seller assumes a higher level of risk, potentially facing an unlimited loss because a security can theoretically rise to infinity. The writer or seller is also required to provide the shares or contract if the buyer exercises the option.

There are a number of options strategies that blend buying and selling calls and puts to generate complex positions meeting other goals or objectives.

2. Single Stock Futures (SSF)

A single stock future (SSF) is a contract to deliver 100 shares of a specified stock on a designated expiration date. The SSF market price is based on the price of the underlying security plus the carrying cost of interest, less dividends paid over the term of the contract. 

Trading SSFs requires a lower margin than buying or selling the underlying security, often in the 15-20% range, giving investors more leverage. SSFs are not subject to SEC day trading restrictions or to the short sellers' uptick rule.

An SSF tends to track the price of the underlying asset so common investing strategies can be applied. Here are five common SSF applications:

• An inexpensive method to buy a stock 
• A cost-effective hedge for open equity positions
• Protection for a long equity position against volatility or short-term declines in the price of the underlying asset.
• Long and short pairs that provide exposure to an exploitable market
• Exposure to specific economic sectors

Keep in mind these contracts could result in losses that may substantially exceed an investor's original investment. Moreover, unlike stock options, many SSFs are illiquid and not traded actively. 

3. Warrants

A stock warrant gives the holder the right to buy a stock at a certain price at a predetermined date. Similar to call options, investors can exercise stock warrants at a fixed price. When issued, the price of a warrant is always higher than the underlying stock but carries a long-term exercise period before they expire. 

When an investor exercises a stock warrant, the company issues new common shares to cover the transaction, as opposed to call options where the call writer must provide the shares if the buyer exercises the option.

Stock warrants normally trade on an exchange but volume can be low, generating liquidity risk. Like call options, the price of a warrant includes a time premium that decays as it approaches the expiration date, generating additional risk. The value of the warrant expires worthless if the price of the underlying security doesn't reach the exercise price before the expiration date.

4. Index Return Swaps

An equity index return swap is an agreement between two parties to swap two sets of cash flows on pre-specified dates over an agreed number of years. For example, one party might agree to pay an interest payment—usually at a fixed rate based on a very short-term interbank lending rate—while the other party agrees to pay the total return on an equity or equity index. Investors seeking a straightforward way to gain exposure to an asset class in a cost-efficient manner often use these swaps.

Fund managers can buy an entire index like the S&P 500, picking up shares in each component and adjusting the portfolio whenever the index changes. The equity index swap may offer a less expensive alternative in this scenario, allowing the manager to pay for the swap at a set interest rate while receiving the return for the contracted swap period.

They'll also receive capital gains and income distributions on a monthly basis while paying interest to the counterparty at the agreed-upon rate. In addition, these swaps may have tax advantages.

5. Contract for Difference (CFD)

A contract for difference (CFD) is an agreement between a buyer and a seller that requires the seller to pay the buyer the spread between the current stock price and value at the time of the contract if that value rises. 

Conversely, the buyer has to pay the seller if the spread is negative. The CFD's purpose is to allow investors to speculate on price movement without having to own the underlying shares. CFDs aren't available to U.S. investors but offer a popular alternative in many major trading countries, including the following:

• United Kingdom
• Germany
• Switzerland
• Singapore
• Australia
• Spain
• France
• South Africa
• Canada
• New Zealand
• Hong Kong
• Sweden
• Norway
• Italy
• Thailand
• Belgium
• Denmark
• The Netherlands

Note that some of the countries above may have heady restrictions.

CFDs offer pricing simplicity on a broad range of underlying instruments, futures, currencies, and indices. For example, option pricing incorporates a time premium that decays as it nears expiration. On the other hand, CFDs reflect the price of the underlying security without time decay because they don't have an expiration date and there's no premium to decay.

Investors and speculators use margin to trade CFDs, incurring risk for margin calls if the portfolio value falls below the minimum required level. CFDs can utilize a high degree of leverage, potentially generating large losses when the price of the underlying security moves against the position. As a result, be cognizant of the considerable risks when trading CFDs.