Finally, A Simple Explanation of Derivatives

The foregoing article was originally written in November of 2012:

Since the bursting of the housing bubble in 2008, derivatives have become a hot topic OUTSIDE of the financial community. Following the '08 crash, lots of people tuned in as the financial media talked endlessly about derivatives being to blame for the entire mess the economy was in (which is only a half-truth). The endless drivel prompted the public to become curious about financial derivatives, but the public has come up short because hardly anyone seems able to explain what derivatives are and their function in a simplistic manner. I'm gonna attempt to do just that.

In recent years, you've heard terms like CDOs (Collateralized Debt Obligation), CDS (Credit Default Swaps), MBS (Mortgage Backed Securities), Futures, Options, and on and on. Those are all derivatives with different functions. But in this article, we're only gonna be explaining Futures, Options and MBS. But first, let's define and explain a derivative.

A derivative is a contract whose value is derived from an underlying asset. Let's take a futures contract for example. A future is a contract in which a buyer and a seller agree on a price of an item (a commodity, currency, fixed income security, interest rates, etc) that is set to be delivered at a future date. Let's use a commodity, crude oil, as an example. By locking in a price, buyer and seller are both protecting themselves against price swings (hedging) in the oil market. Until delivery is made, the value of that futures contract can either rise or fall. But since buyer and seller have already locked in a price, neither will pay any more or sell for any less. How does the value rise or fall? That depends on whether crude oil itself appreciates or depreciates in value. It is now obvious that the value of the contract is derived from the physical Crude Oil. By the way, given that explanation of a futures contract, you should also understand that a lot of companies use futures contracts to hedge against price swings in the raw materials which they use for the manufacturing of their products. Some also use futures contracts to hedge against the rise or decline of a country's currency, but that's beyond the scope of this article.

Another form of derivatives are options. To make it simple, I'll explain options this way: options are a contract to that gives a buyer the OPTION (but not the right) to buy an item by a certain expiration date. Vice versa with selling an option. For example, Apple is currently trading at 596.54. You think that Apple is going to $625 within the next month. You buy an out of the money call option on 100 Apple shares with a strike price of $600. If Apple reaches $600 and above, your option is now in the money...making it profitable. To buy those shares outright would cost you $59,654.00 plus commissions. But with a call option, you'd be controlling 100 shares for a premium of around $400. That's nearly 150:1 leverage. The value in that option derives from the price of the Apple shares.

Now we're gonna discuss the derivative instrument that's usually on the forefront of those discussing the '08 meltdown --- Mortgage-Backed Securities (MBS). A MBS is a security in which an underwriter packages a bunch of mortgages into a sellable security. When an investor buys a MBS, the interest income the investor receives is derived from the mortgages of the homeowners who's mortgages have been packaged into the security he owns.

So, how did derivatives play a role in the 2008 meltdown? When homeowners began to default on their mortgages, that sent the mortgage-backed securities market in a tailspin. The value of MBS' plummeted damn near overnight. Because investors (or should I say speculators) were losing so much money and so fast, it was also hard to get out of those toxic investments; no buyers! Many investors had no choice but to watch their net worth melt away. In the derivatives market, if an investor isn't able to close their position, they stand to not only lose their entire investment, but they can also end up owing heavily. That's what ended up happening. Because so many investors were highly leveraged to purchase MBS, they ended up losing more than they invested; which is how a few bulge bracket banks ended up going under --- Lehman Brothers, Bear Stearns, Merrill Lynch, etc.

Losing money in a derivative position is not like losing money in stocks. If you own 100 shares of stock at $25 a share, you paid $2,500 worth if you bought those shares at $25. If the stock's value declines to $23, you've lost $200. But with derivatives, its not that simple. Back to our Crude Oil future as an example. One crude oil future allows the trader to control 1,000 barrels of crude with only a small margin payment of around 5%. If crude is trading at $86, that would mean that a futures contract on crude is worth $86,000. But, you can buy one contract and control that deal for $4,300. That's 20:1 leverage.

If you have a position of one Crude Oil future, each whole dollar Crude Oil moves up is worth $1,000. So, if Crude Oil goes up or down a dollar, you've made or lost $1000. If you've paid a margin of $4,300, imagine oil moving $5 against your position, you're not only lost your margin investment, but you now owe $700. Imagine someone with a position of 10 Crude Oil contracts! That would be $10,000 lost or made for every dollar crude oil moves. If the trade goes against the trader, he could end up owing tens of thousands of dollars (a smart player would cut his losses short anyways). Keep in mind that the numbers could change depending on how much leverage you're using. The higher the leverage, the bigger the numbers. That is why a lot of investors are deathly afraid of derivatives and won't touch them with a 10 ft. pole. But on the flip side, a lot of people have gotten really rich trading derivatives.

Derivatives are attractive to many because of the amount of leverage they offer and the huge profit potential if the trade is successful. A trader (or investor) can control a very expensive deal with only a small amount of money (as explained above). Not only that, derivatives are also a great tool for hedging (as also explained above). But if a person is looking to profit from the price moves of derivatives, that person is a speculator.

Don't get the impress that derivatives are a new instrument. Derivatives have been around since the days that the Dutch ruled the East-West trade, which was during the 1600s. Actually, derivatives were around before then. But we can actually trace them to that time period.

Since derivatives are a contract who's value is derived from an underlying asset and are usually highly volatile, that's why is you often hear people refer to today's wealthy as being rich only on paper. I can't endorse that point of view in its entirety, but I do understand why they would say that...mainly because a portfolio with derivatives can earn a person a net worth millions, but a with a violent price swing, those millions could vanish even faster than they came. But, in closing, the point is this: Despite the bad rap some market participants try to give derivatives, they're here to stay. A lot of money can be made or loss trading derivatives, that's why it pays to know what you're doing.