Derivatives investment occurs when investors put money into a financial instrument that is derived from some underlying security. The goal in this type of investment is to speculate on the price movement of the underlying security without actually gaining ownership of it. Many people use derivatives investment as a way to hedge against another type of investment to minimize risk. It is wise to learn as much as possible about derivatives, which can be a confusing enterprise, before undertaking to invest in them.
People who invest in stocks on the open market actually gain an ownership share of the companies in which they invest. This usually requires a considerable commitment of capital, and it generally takes a long amount of time before the investment returns a significant profit. By contrast, derivatives investment allows for investors to get involved with blue-chip securities for a relatively small cost. In addition, the potential is there for them to gain significant profits in a relatively short time period, although the risks are there for great loss as well.
Some people use derivatives investment strictly as a way to hedge against other securities within their portfolio. For example, an investor who owns a significant stock in a single company can actually use common derivatives like options to protect against the stock taking a dive. This is done by buying a put option on the underlying stock, which essentially gives the right to the investor to sell the stock if it falls below a certain price. In this way, he is covered no matter which way the price of the stock moves.
Since much of derivatives investment is based on the way underlying securities will be priced in the future, it is sometimes difficult for investors to gauge how much certain derivatives contracts are worth. In the case of options, there are options pricing models that can judge approximately how much an option contract will be worth when the underlying security moves in price. The investor can then use her speculation on the future price of the security and refer to the pricing model to determine how much the derivative is worth.
Any investor wishing to partake in derivatives investment should be aware of the risks involved and the complicated nature of the market. For that reason, investors should consider a practice known as paper trading for a period of time before risking actual money on derivatives. Paper trading occurs when an investor makes imaginary trades on a simulated account without incurring any actual risk. In this way, the investor can get a feel for derivatives and their many permutations before putting together a real account.