Derivative financial instruments are among the most complex securities that are traded in the financial markets. These securities include options and futures contracts, which can trade on major commodity exchanges. Derivative financial instruments are not assigned a value by themselves. Instead, a derivative's worth is based on another underlying security, such as a stock or bond. Derivatives can greatly enhance an investor's returns but can also lead to more severe losses than investing in traditional stocks and bonds would incur.
Options are among the types of derivative financial instruments. The person who buys an options contract holds much of the control over the fate of that trade. For instance, the buyer of a call option can buy stock in a company at a predetermined price, dubbed the strike price, over a given time frame and before an expiration date. A call investor is not obligated to buy those shares, however.
The other side of a call options trade is a seller, or writer of the options contract. Although the buyer can walk away from an options trade before the expiration date, the seller, or call writer, on an options contract has no choice but to sell the security if the call investor wants to follow through with the trade, even if it means the writer takes a loss. This is one reason why trading derivative financial instruments can be risky.
Another way to buy options is to purchase a put contract. In this trade, the seller has the option to sell an underlying security at a preset price to a buyer within a given time frame. If this investor prefers to sell, the buyer, known as the put writer, must purchase the shares at the strike price, even if it means purchasing the shares at a higher price than desired.
Futures are another type of derivative financial instrument. The underlying securities in a futures contract could be commodities, such as oil or gas, or agricultural products, such as cotton. Futures traders can buy or sell these securities at a preset price at a future date in time. Once purchased, the physical asset can be delivered, or the contract can be settled with cash instead.
The trading of derivative financial instruments is often dominated by professional money managers, including hedge funds. Hedge funds are lightly regulated investment vehicles that combine the assets of multiple investors and that are overseen by professional portfolio managers who charge hefty fees. These money managers use derivatives as a means to enhance the potential returns on an investment and to mitigate losses because they understand sophisticated investment strategies.