If you are interested in investing your money on financial markets, you have probably come across the term 'derivatives'. You can use derivatives for pretty much every type of financial asset which is traded (e.g. stock, currencies, bonds, commodities), but unlike common trading, you are not actually buying (or selling in some cases) a financial asset when you use them. Confusing, yes?

Instead, you are making a contract with another party (which could be your own broker). When a derivative is originally created, you and the other party agree to do something with a particular financial asset (for example, to trade between one another a quantity of shares in Microsoft at a particular price) in the future. No change of ownership of the actual financial asset which the derivative contract refers to occurs while the contract is still running (and in some types of derivatives there is never any change of ownership of the financial asset).

However, with many types of derivatives (but not all), after these contracts have been originally created between two parties, just like with the actual buying and selling of the actual shares in a company or units of a bond, these contracts can be freely traded between people on exchanges. So you can sell on your derivative contract to other traders/investors before the contract ends/expires.

Although in theory derivatives are quite simple, they are just contracts/agreements to do things, in reality they are quite confusing to understand (and explain). What complicates the matter further is that there are many different types of derivative contracts, some where the agreement is to not actually buy or sell a particular financial asset at a point in the future.

In this online exercise on derivatives through reading a dialogue and then answering some questions, you will learn what five of the main types of derivative contracts are and how and why they are used.

The purpose of this exercise (which includes a reading exercise and then a quiz) is not to give you financial advice about how to invest your money on financial markets, but to help you to understand better what types of derivatives there are.

If you don't know a lot about trading financial securities, I would recommend you do our online exercise called 'Types of financial trading' first. It will explain to you what the different types of financial assets which derivative contracts are used to trade in.

Exercise: Explaining derivatives

Read the following conversation between two friends, Peter and Juan, where Peter explains to Juan what the different types of derivative contracts are.

From the context, try to guess what the meaning of the words/phrases in bold are. Then do the quiz at the end to check if you are right.

Juan:'I am a little confused about what a derivative is. So do you mind if I just clarify with you what my understanding of what a derivative is?'

Peter:'Sure, go ahead!'

Juan:'So when you use a derivative, you are not buying an actual financial asset like shares in a company or units of a commodity like gold on an exchange, are you?'

Peter:'That's correct, you are not.'

Juan:'Instead, you are entering a contract with someone else where you agree to buy from them or sell to them a specific quantity of a financial security (e.g. shares in a company or units of gold) at a specific price by a specific date in the future?'

Peter:'You are partially correct. All derivatives are indeed contracts between two different parties, but there are different types of derivative contracts. What you are describing (where you agree to buy from them or sell to them a specific quantity of a financial security at a specific price by a specific date in the future) are called futures. When a futures contract reaches its agreed expiry date both the parties who own the contract are legally obliged to sell to or buy from the other party the quantity of the financial security at the price which is stipulated in the contract.'

Juan:'But if I owned a futures contract, would I be able to sell the contract to someone else before it expires?'

Peter:'It depends on what is stipulated in the contract, but for most futures contracts you can freely trade futures on an exchange through your broker before it reaches its expiry date. But the price you will receive for trading any of these types of derivatives will depend on both how long remains for it to reach its expiry date and how profitable holding that contract is predicted to be for the owner when the contract reaches that expiry date. So if you have a futures contract where you agree to sell a specific quantity of a financial asset at a specific price (called the delivery price) in a month's time and the current/spot price of the financial security is a lot lower than the delivery price, your futures contract will trade for a higher price (because it is highly likely to make a profit) than what you originally paid for it. The reverse would happen if the current/spot price of the financial asset was a lot higher than the agreed delivery price.'

Juan:'So investing in futures is like betting. You are betting that the price of something is going to go up from the current/spot price, aren't you'

Peter:'In a way most trading on financial markets is a form of betting, speculating whether the price of a financial asset will go up or down. But unlike with betting whether a sports team will win or lose, with futures as I said before, you take ownership of the asset at the expiry date of the contract.'

Juan:'It is different to betting on sports.'

Peter:'However, there is a type of derivative which is exactly like making a bet on the performance of a sports team, but betting on financial assets (like shares, currencies etc...) instead. And these are called a Contract For Difference or CFDs for short.'

Juan:'And how do they work?'

Peter:'Basically, a trader enters a private agreement with their broker where if there is a change in the future from the current/spot price of a financial asset, either of the parties will pay the other the difference. So if you expect the price of a particular company's stock to go, you would enter a CFD with a broker where if it does, the broker would transfer to your account when the CFD ends the increase in price multiplied by how many shares the CFD you both agreed covers (e.g. 500 shares).'

Juan:'And what would happen if the price of the stock fell?'

Peter:'It would be the other way around, the broker would take out of your account with them when the CFD ends the decrease in price multiplied by how many shares the CFD you both agreed to cover. You can also do a CFD with a broker where you bet that the price of a financial asset will fall. In this case, you will pay them if the price goes up and they will pay you if it goes down. '

Juan:'So, are there any other types of derivatives which I should know about?'

Peter:'Yes, there are. There are two which are very similar to futures, put options and call options'

Juan:'How are put options and call options different to futures?'

Peter:'Both are very similar to futures, in that they are contracts to either sell or buy a specific quantity of a financial security at a specific price by a specific date in the future. And you can freely trade them before they reach their expiry date. However, with futures contracts both parties are legally obliged at the expiry date to buy or sell from the other the agreed amount of the financial security at the agreed price. Whereas with put options and call options, the person who enters the contract has the option to pull out of it whenever they want. Hence, the name.'

Juan:'And what about the person or organisation who originally creates the contract? Can they pull out whenever they want?'

Peter:'No. The person or organisation which creates (originally sells) either a put option or call option contract is legally obliged to honour the contract if the buyer of the contract wants to go through with the contract at the expiry date of the contract.'

Juan:'It doesn't make sense! Why would anybody create a put option or call option contract, if the buyer of the contract can pull out of it whenever they want'

Peter:'Because the creator charges a fee which the original buyer of the contract has to pay when they take the contract.'

Juan:'Now that makes sense. But what is the difference between a put option and a call option?'

Peter:'They are basically the same except for one difference. With put options, the owner of the contract agrees to have the option to sell a specific quantity of a financial asset at a specific price at a future date. Whereas with call options, the owner of the contract agrees to have the option to buy a specific quantity of a financial asset at a specific price at a future date.'

Juan:'I think all four of the derivatives you have mentioned are quite easy to understand. Are there any other types of derivative contracts which are used in financial markets?'

Peter:'There are others, like forwards and warrants, but they are not things which are commonly traded or need to be known about by the majority of people who invest their money in financial markets. Having said that, there is another which unless you are very rich or a big organisation you are not going to use, but you may hear people talking about, and these are derivatives called swaps.'

Juan:'I have actually heard about them before, but I have no idea what they are. I know that swap means for two people to exchange the ownership of things between themselves. Are swap contracts agreements for two parties to exchange the ownership of two different financial assets between each other?'

Peter:'No. Instead of two parties exchanging the ownership of a financial asset from each other, in a swap they exchange only the financial responsibility of a financial asset from each other for a period of time.'

Juan:'Ok! So what is the difference between owning a financial asset and being financially responsible for a financial asset?'

Peter:'Apart from when owning a financial asset you can choose to sell it whenever you want, there is pretty much none. Both parties in each are financially responsible for an asset. That means that they are both responsible for the benefits or the costs which the financial asset they are responsible for makes. So two parties could enter a swap agreement to exchange the financial responsibility of some bonds they own. One bond could pay a fixed interest rate, while the other could pay a variable interest rate.'

Juan:'And with a swap, each party would be paid the interest rate of the bond which the other party owns?'

Peter:'Yes, they would. And there is a difference between the money they make between the two.'

Juan:'So, a swap is like each party being a kind of temporary owner of the other's financial asset for a period time.'

Peter:'It is kind of like that.'

Juan:'So why do investors enter swap agreements?'

Peter:'It is basically done to diversify your investments and reduce your exposure to risk. So, if you are an investor that owns a lot of fixed interest rate bonds, if the general interest rate goes above that, you wouldn't be making as much money as if you owned bonds that paid a variable interest rate. So by entering a swap agreement to exchange some of your fixed rate bonds with another investor for their variable rate bonds, you would make more money if that situation occurred'

Juan:'So swaps are a kind of insurance in a way, aren't they?'

Peter:'Kind of. It's what is called hedging in the financial world, where you take the opposite position in your investments to reduce risk of losing too much money if things go badly.'

Juan:'That makes sense.'



Quiz:

Match the words/phrases in bold from the above text to each of the definitions/descriptions below. Click on the "Check" button at the bottom of the quiz to check your answers.

When the answer is correct, two icons will appear next to the answer. The icon contains extra information about the word/phrase. In the icon, you can listen to the pronunciation of the word/phrase.

1. A type of derivative where you have the choice of whether you sell or not a financial asset at a specific price to someone in the future, are called

         

Put options:
(noun) This is a type of derivative. A 'put option' is like a type of insurance when buying a financial security which is used to reduce a potential loss if the price of it falls in the future. It is a legal contract with a third party where you agree to have the option to sell (it is your decision if you do or not) to them a specific quantity of a financial asset (e.g. stock in a particular company, a specific bond etc...) at a pre-set price on or before a specific date in the future.

As it is a contract, the entity which creates the put option (called the 'writer') is legally obliged to buy from you the financial asset at the agreed price (called the 'strike price') if you decide to proceed with the sale (take up the option) within the terms of the contract. To make it worth their while, the writer/creator of the put option will charge a fee (called a premium) to the investor who originally buys the put option contract from them and this is non-refundable.

The amount of this fee/premium varies on a number of different factors (e.g. the price the financial security will be bought at, the probability the financial security will reach that price in the market, length of time until the contract expires etc...). On put options for stock, you have to pay a fee/premium for each share you buy (e.g. $0.45 per share). In addition, there will be a set minimum quantity of the financial security that you would have to sell if you chose to do it. With stocks, it is normally 100 shares. Put options can be directly bought or traded through brokers.

Instead of choosing not to go through with the contract or settling it with the original writer of the contract, you can also resell the put option contract to another person through your broker before it reaches its expiration date. If you do, you will also receive a fee from the person who has bought the contract from you. This fee will probably differ from the fee you originally paid as a result of a change in the perceived profitability of owning the contract.

Although put options are often used by investors who already own the financial asset when they buy the contract (to reduce potential losses if things go bad), some investors/traders who use them don't. These investors/traders are not using put options to reduce losses (if the price of the financial asset falls), but to make money. In such a case, the investor/trader is taking a short position, speculating that the price of the financial security will fall on the market.

If an investor/trader is using a put option to make money, not only when the contract expires does the spot/current price of the financial asset need to be lower than the strike price (the agreed selling price), but the difference between the two has to cover both the fee/premium paid per unit for the put option and also the commission per unit (charged by the broker) to buy a unit of the financial asset (e.g. 1% of its value). If the difference between the prices doesn't cover these, the option would make the investor a loss.

For example, if you buy a put option contract for a company's stock at a strike price of $25 and pay a fee of $0.50 for each share and pay a commission of $0.23 for buying each share, in order to make money you would need the actual share price to be below $24.27 when the option expires.

With some put option contracts, no actual trading of the financial asset it refers to occurs when the option expires/ends, but the two parties settle the difference between the spot/current and strike prices in cash. These are called 'cash-settled' opinions.

The opposite of a put option is called a call option, this is a derivative contract with a third party where you have the option to buy stock for a specific price in the future.

Close

Put options:
Close

2. A type of derivative where you bet with someone whether the market value of a financial asset will go up or down in the future, but involves not change of ownership of the asset, are called

         

CFDs:
(noun) CFD stands for Contract For Difference. This is a type of derivative contract where people speculate on the future price of a specific financial security (e.g. shares, currency, commodities etc...). But unlike other types of derivative contracts (like futures, call and pull options) a person using a CFD never has any intention of taking ownership of the financial asset the CFD refers to.

It is a contract entered into between a trader and normally their broker where the trader speculates whether a specific financial asset's value on the market will rise or fall. In effect, the two parties enter into a bet with one another (like you would do when making a bet on sports).

An example will illustrate better what they are. Say you think that shares in the retail company Walmart are going to go up and you enter a CFD agreement with your broker for 100 shares/units of the company. If they do go up from the price they are at the start of CFD, your broker will pay you on the date the CFD expires/closes this difference in share price times 100 shares/units. However, in the reverse situation where the company's price falls, you will be liable to pay your broker the difference in value of the share price times 100 shares/units.

So even though at no time does the trader actually have actual ownership of the financial asset they have entered a CFD for, when the CFD closes, it is like in many ways they had. In fact, they use the terms 'buy' and 'sell' on trading platforms for CFDs, where 'buy' means that the trader is betting that the value will go up and they will profit if it does, and 'sell' means that the trader is betting that the value will go down and they will profit if it does.

When a CFD is closed, money is transferred between the trader and broker who created the CFD. The amount and to whom it goes to depends on who won the bet. If the trader did, the broker will transfer funds (their winnings) to them. If the broker did, they will transfer funds out of the traders account with them.

This type of derivative contract is illegal in the US, but is legal to do in many other countries, including the UK, Japan, Germany.

Close

CFDs:
Close

3. A type of derivative where two parties agree to exchange the money they make from a financial asset owned by each other for a set period of time into the future, are called

         

Swaps:
(noun) It is a type of contract between two parties where each agrees to take financial responsibility (but not ownership) of the other's financial security/asset for a fixed period of time. What this means in the basic form of a swap is that each agrees to pay the other's liability (e.g. interest payments) and receive the other's income (e.g. dividend) from a specific financial security they have agreed to exchange for a specific period of time.

Although swaps are very often done with ownership of loans/bonds to other peoples (called 'interest rate swaps' where each party agree to receive the interest payments on the loan/bond that each other owns for a set period of time), swaps are also made with other financial securities/assets as well (including stock, commodities, currencies etc...).

Unlike other types of derivatives (e.g. futures, options etc...), with a swap there is never any actual trading (change of ownership) or option of trading of the financial asset which the contract refers to either during or at the end of the contract. It is basically like two people making a bet on what will happen (e.g. interest rates or a share price going up or down).

In addition, unlike other types of derivatives which can easily be traded, with swaps it is a private agreement between two parties. If one of the parties wants to end the contract or even sell their swap contract to another party, they need to get the agreement to do this from the other party they entered the agreement with.

As a result, swaps are normally done by large institutions (e.g. a hedge fund, an investment bank) and companies. And although some of these large scale investors do use swaps to speculate and make money, they are more often than not used by large institutions and companies to hedge (reduce the risk of losses) by taking the opposite position on an investment they have made.

For example, a large company may have made a large amount of fixed rate outstanding loans, may make a swap agreement with a financial institution for a variable/floating loan that they own. So if the general interest rate increases over a specific amount, although they are losing money from the fixed rates which they made, this loss is reduced by the money they make from the interest payments they receive as part of the swap they have made.

Close

Swaps:
Close

4. A type of derivative where one party agrees to buy from or sell to another a specific quantity of a financial asset at a set price in the future, are called

         

Futures:
(noun) It is a legally binding derivative contract with another investor to buy or sell a specific quantity of a financial asset (e.g. stock in a company, bond, commodity etc...) at a specific price at a specific date in the future. Futures trading are done through an exchange (e.g. the Chicago Mercantile Exchange) which guarantees that all contracts are honoured.

As it is a contract, the entity which creates the futures contract (called the 'writer') is legally obliged to buy from or sell to you the financial asset at the agreed price (called the 'delivery price') or settle the difference in cash.

If it is a futures contract to buy, at the end of the contract the investor who owns the contract can either take ownership of the actual financial asset which the contract refers to (e.g. the shares in the actual company) by paying the price agreed in the contract, or receive or pay a cash payment instead (for the difference between the actual price and what they agreed in the contract to buy it for). With cash payments, if the futures contract is to buy a particular financial asset and the price of the financial asset is higher than what they agreed to pay, they will receive a payment from the other party for the difference in value. If lower, they will have to pay the other party the difference in value. The reverse is the case when having a futures contract to sell.

Futures contracts can be bought through a broker and can be subsequently traded (bought and sold) between investors on an exchange after they have been created.

Close

Futures:
Close

5. A type of derivative where you have the choice of whether you buy or not a financial asset at a specific price from someone in the future, are called

         

Call options:
(noun) This is a type of derivative. Instead of buying a type of financial asset (e.g. stock in a listed company, currency, a type of bond) you can buy a contract that gives you the option to buy it or not at a specific quantity at a specific price either at or within a specific amount of time in the future. This is called a 'call option' and it is basically a type of insurance to reduce the potential loss you could make on a trade.

As it is a contract, the entity which creates the call option (called the 'writer') is legally obliged to sell you the financial security at the agreed price (called the 'strike price') if you decide to proceed with the purchase (take up the option) within the terms of the contract (up to or on the expiration date of the call option). To make it worth their while the writer/creator of the call option will charge you a fee (called a premium). For call options on stock, you will have to pay a premium (e.g. $0.45 per share) when you buy the call option and this is non-refundable. With call options, there is a minimum quantity of the financial asset that you would have to buy if you chose to do it. With stocks, it is normally 100 shares.

In order to make money on a call option at the time the option expires/ends, the price of the financial security needs to be higher than both the strike price and fee combined, if not you would make a loss. For example, if you buy a call option contract for a company's stock at a strike price of $25 and pay a fee of $0.50 for each share, in order to make money you would need the actual/spot share price to be over $25.50.

As said, it is your option to decide whether to buy it or not. So if you don't take up the option, the potential loss would be restricted to the amount of money you originally paid in fees for the call option. Hence the reason why some investors purchase them.

With some call option contracts, no actual trading of the financial asset it refers to occurs when the option expires/ends, but the two parties settle the difference between the spot/current and strike prices in cash. These are called 'cash-settled' opinions.

The opposite of a call option is called a put option, this is a derivative contract with a third party where you have the option to sell stock at a specific price in the future.

Close

Call options:
Close





Practice

Now that you understand the meaning of the words/phrases and when to use them, practise using them by creating your own sentences with them in English. Also click on the "" icon next to each correct answer and listen how each is pronounced correctly.