Derivatives: what are they? How do they work?

Derivatives: what are they, how do they work, and why are they so profitable? If you want to know, read this article to learn how the derivatives market can be a golden opportunity!

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In Brazil, derivatives have become increasingly common, primarily in their function of protecting contracts, debts, cash flow against fluctuations and exposure to the balance sheet of companies and to manage risks against unwanted fluctuations. And also as an investment option, which is what interests us today.

But many people only have a superficial understanding of derivatives, which are used to protect investments, but they don't really know what they are or how they work. Many investors already understand a little more, and know that through derivatives it is possible to obtain a good return on the market.

And because derivatives can be used to move small amounts, they have become very popular among investors in Brazil, especially attracting the attention of individuals.

You may have heard of swaps, options and futures contracts, but you may not know exactly what they are. All of these terms are names for types of derivatives, and we will go into detail about how they work, and talk more about each one.

What are derivatives and how do they work?

First let's talk about what derivatives are: contracts where the value is derived (hence the name) from an underlying asset. These assets can be physical in nature, such as agricultural products, industrial machinery, and even gold. But they can also be financial assets, and their price would be derived from other assets, such as stocks, or from interest and exchange rates.

We will talk more about the different types of derivatives later, but just to clarify, let's name the four most commonly used types: fixed-term contracts, futures, options and swap contracts. Derivatives act as a hedge in the present against future price fluctuations, providing a guarantee of the price that is fixed by the contract.

This is why derivatives are used for speculation. The speculator negotiates the price and can profit from the price difference in the future.

So when we talk about investing in derivatives, we are actually betting on a price differential in the contract over time.

We have already discussed how derivatives serve to protect companies, but now let's talk a little more about derivatives speculation. It is possible to day trade with derivatives, buying and selling on the same day according to price fluctuations.

In fact, it is also possible to keep the derivative trade open for days, waiting for a rise in price and then making a sale.

Another way to make money with derivatives is through arbitrage.

Arbitrage means profiting from the price difference between different markets for the same product. In theory, it is very simple: buy the derivative where it is cheaper and sell it where it is more expensive. However, the profit is usually lower, and it can be more profitable if trading in larger quantities.

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What are the types of derivatives in the financial market?

As we said, there are four most common types of derivatives in the market. Let's detail them one by one now, so that you understand this derivatives market more fully.

Fixed-term contracts

Anyone who buys a forward contract is committing to a specific price for an asset, established in the contract negotiation, to be paid on a date in the future.

Basically, “locking” the price of the asset so that the company can keep its future expenses or earnings under control and thus avoid losses. In this contract, the settlement of the transaction occurs on the due date.

Futures contracts

They are very similar to the previous modality, in the sense that the company is negotiating an asset now, and already establishing the price, to buy or sell in the future.

The big difference is how the contract is settled.

In the case of the settlement of futures contracts, there is the so-called daily adjustment, where all futures contracts that investors hold are valued daily based on a daily settlement price, which is a reference for the daily valuation.

The difference in the daily settlement price and the previous price is assessed, and the investor then has to pay the difference if the settlement is negative, and receives income if the settlement is positive.

These are traded only on Exchanges.

Options

Options work as if they were the promise of being able to buy or sell the asset related to the derivative in the future. The buyer of the option pays the seller an amount, called a premium, and then gains the right to sell an asset for a fixed price in the future.

The buyer of the option is called the holder, and has the right to exercise the option to buy or sell the asset on the expiration date, at the fixed price agreed upon at the beginning.

You also have the right to let the option expire, losing only the premium paid. The option seller, the so-called writer, will always have the obligation to exercise the option if the holder wishes to exercise it.

To simplify, let's imagine that a holder buys stock options in a company. If this holder wants to exercise his right to buy the shares, on the expiration date of the options, the writer is obliged to obtain the shares to sell to him at the negotiated price.

Swaps

Think of swaps as the exchange of profitability between two assets.

A swap is a contract in which two parties negotiate the profitability of one asset compared to another, as if they were exchanging cash flow between them, based on a reference value.

Many call this process “risk shifting,” as both parties are negotiating the profitability of two different assets or commodities.

A classic example to understand how this derivative works is to imagine a gold swap made against the Ibovespa. Thus, one party will pay the other the variation that is due to it.

One pays the variation of gold to the other, and receives the variation of the Ibovespa, and the opposite happens with the other party, receiving the variation of the other and paying the variation of the Ibovespa.

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What are the risks?

The promise of high profits when investing in derivatives is proportional to the danger of prejudice, and that is why we consider investing in derivatives to be riskier.

In the specific case of the derivatives market, the risk depends largely on the investor's knowledge of the subject. The more knowledge the investor has about the subject, the safer the investment will be. Without the necessary knowledge, each investment will seem like a gamble – a shot in the dark, without knowing whether or not it hit the target until it is too late.

Precisely for this reason, it is usually more suitable for those who are more experienced and who dedicate more time to studying the subject.

The investor profile that best suits derivatives is the aggressive profile – the risks are higher than average. Knowing how to analyze graphs is crucial to making the right decision and achieving profit, rather than losses, which can occur.

The risks associated with the derivatives market arise from the fact that these investments are highly speculative, and depend heavily on future and uncertain factors.

As we said, with good knowledge it is possible to reduce this risk, but it will always be present. The economy is unpredictable and the prices agreed upon in the present may not reflect well on the prices being paid in the future.

There are also risks associated with fluctuating derivative prices, as these are traded on the stock exchange, and Investments in derivatives are not guaranteed by FGC (credit guarantee fund) and does not have any form of guarantee of results.

But don’t be discouraged. If you are an investor with a more aggressive profile and are looking for an investment that promises high profits, remember that the risks will always be proportional to the returns. The risk may be great – but so is the opportunity.

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What are the advantages of investing in derivatives?

Derivatives come with two major advantages that make investing very attractive to many people: offer protection against fluctuations or the possibility of high returns in a very short space of time.

Regarding derivatives protection, they are normally used by those who need to protect themselves from fluctuations in the prices of foreign currencies or commodities on the market.

An example of this is a company that uses a derivative linked to the dollar exchange rate on a given day, and thus counts on that currency price for a given period of time. We call these types of operations hedges.

And now, the big advantage that investors in particular are most looking for when dealing with derivatives: high returns in a short period of time. Of course, as we said, the risk is high too.

To achieve these high return values, the investor takes a position that has little relation to what is happening in the market at the moment, and makes a bet for or against an asset.

Let's say the investor made this speculation on an asset, and bet that the price of the asset would rise dramatically in a short period of time: if the speculation pays off, and the price of the asset rises, the profits can be huge!

At this point, it would be prudent to reiterate that investing in derivatives is not recommended for beginners..

The risks are extremely high and knowledge about derivatives must be very good in order to make calculated speculations. However, for those who want to invest without any knowledge, hiring a specialist professional is always an option.

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How to invest?

Firstly, it is good to know your investor profile, to understand whether derivatives are really the best investment option for you.

If, after discovering your investor profile, you decide that derivatives are indeed an attractive investment, then it is time to choose a good broker so that you can trade derivatives. Choose well: a safe broker that doesn't make miraculous promises of returns, do your research well so you don't regret it in the future.

Then, it's time to analyze the derivatives, choose which types you want to invest in, and study them until you understand them very well. Without knowing what you're dealing with, it's impossible to make a decision and choose a modality to invest in.

Finally, it is always very prudent to define a strategy for investing in derivatives. If a strong strategy is already necessary in the spot market, imagine what it is like in the derivatives market, which deals with speculation on the future price of assets.

With a solid strategy, you can be more successful in your derivatives investments.

And now to the point: a step-by-step guide on how to invest in derivatives in practice.

1. Open an account with a stockbroker;
2. Transfer funds to your brokerage investment account so you have money to trade;
3. Access the home broker of the brokerage firm of your choice, analyze the assets and then start trading
4. Monitor the market and the performance of your derivatives investment until the agreed date.

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Conclusion

The derivatives market serves as protection for companies, and is therefore widely traded by legal entities. As an investment, they are variable income assets, and therefore have their risks that should not be forgotten at any time.

But investing in derivatives can be a very profitable option for those who are willing to take risks, but mainly to study and inform themselves very well to minimize losses.

Start small, test the waters and see how the derivatives market works. The best learning is actually through practice, and experience can give you the knowledge you need to make real profits.

And if you are just starting out, the ideal is to look for other ways to invest your money, with applications that offer less risk, such as multimarket funds, without having to give up a respectable return.