What Are the Pros and Cons of Financial Derivatives?

Financial derivatives are generally contracts agreed upon between two parties whereby the values of the contracts are tied to the values of some underlying financial instruments, such as stocks or commodities. Using derivatives can be an effective way for investors to hedge the risks they have incurred from purchasing other securities. It can also be a way for an investor to speculate on the price of some security at a fraction of the cost of actually purchasing the security. The downside of financial derivatives is that they can be extremely complex and can lead to heavy financial losses if not executed properly.

Most casual investors only think of investing in terms of stocks or bonds. These are relatively simple instruments but they represent only a small portion of the investment opportunities available. For more advanced investors, financial derivatives, like options or futures contracts, are often valuable for both their flexibility and relatively lower costs. To put it simply, a financial derivative derives its value from some underlying instrument. Derivatives can be effective investment tools, but, like all investments, they carry significant risks as well.

Many investors use financial derivatives primarily as a method of hedging the risk of other investments they have made. For example, imagine that an investor has heavily invested in the stock of a certain company. To hedge his or her risk, he or she could buy an option known as a "put," which confers the opportunity but not the obligation to sell shares of that stock at a predetermined price. In this way, the put can offset the risk of the price of the stock plummeting.

Investors who prefer to speculate on the prices of stocks or other securities can use financial derivatives as a way of doing so. Derivatives contracts can usually be bought and sold at a small percentage of the actual price of the underlying instrument. Since this is the case, investors can take on the relatively small price of the derivatives contract and hope to reap the rewards in the future if the price of the underlying security moves in the expected direction.

As with all potential investments, financial derivatives carry significant risks. Derivatives can be extremely complex, and the casual investor might not understand the risks involved. In addition, many investors use leverage to become involved in derivatives, which means that they are essentially borrowing money from their brokers to make the investments. Such leveraging can be particularly damaging if the derivatives perform poorly.