Some of the biggest money made and lost comes from investing in the options, futures and other derivatives markets. What exactly is the derivatives market? Well, to put it simply, derivatives are side bets on stock prices, interest rates, and commodity prices and so on and so forth. Derivatives are a way for investors and companies to control risk on their part.

How does the derivative market leverage risk?

Well, to understand how options, futures and other derivatives work, one has to understand the differences between the types of derivatives. There are four primary types of derivatives that the market has been trading with rapid frequency:

  1. Options
  2. Futures
  3. Forwards
  4. Swaps

Options are a prospective side-bet on the price a stock will rise or fall by. Futures have to do with a prospective side-bet on the price of a commodity or transaction. Forwards are special futures that have to do with currency; and Swaps are a way of hedging against the volatility of one currency against another.

Confused? Well, this is something that has to understood in order to learn how stock market investors really make their money.

What’s the Difference

Options are sim;e. They have to do with the fact that you think a price is going to rise or fall. So, you buy the stock at a certain price from now until up to a certain date. If the price rises as you expected, they can call in the option and make a profit by buying at a lower price than listed.

Futures are a bit trickier. Say someone has a farm and they are expecting a big yield. Obviously, they want to control the price so that they will make some profit off of their crops. Instead of waiting for the price to rise and drop, they decide to make a Futures deal.  They sell their crops a few months from now at a price that they have set today. If the price at a few months from now is higher than the set price today, the investor wins.  The supplier/farmer has lost a great amount of futures profitability by selling too low.  But he still made a profit!  However, if the price is lower, the investor paid more than the yield is worth and the farmer walks away with a smile.

Forwards and Swaps have to do with currency. Forwards work like futures except they deal with money. Say an investor believes that they are going to receive X amount of euro’s for example, but they don’t trust the way the euro-dollar exchange rate works. They then arrange a Forward contract, setting the exchange rate at a certain agreed price. When the time comes that the X amount of euros falls into their possession, they exchange them at the price that was agreed on the Forwards contract. Swaps are just that – investors swap one currency for another because they believe one is less reliable than the other.

A Side Note on Options, Futures and Other Derivatives

in order to make a derivative market transaction, one has to pay a premium because the investor is making a bet on how things will turn out for their bet. Some refer to this as the price for profitability.