Why derivatives are used for speculation

Futures contracts, forward contracts, options, swaps , and warrants are commonly used derivatives. A futures contract , for example, is a derivative because its value is affected by the performance of the underlying asset. A futures contract is a contract to buy or sell a commodity or security at a predetermined price and at a preset date in the future.

Futures contracts are standardized by specific quantity sizes and expiration dates. Futures contracts can be used with commodities, such as oil and wheat, and precious metals such as gold and silver. An equity or stock option is a type of derivative because its value is "derived" from that of the underlying stock. Options come in forms: calls and puts. A call option gives the holder the right to buy the underlying stock at a preset price called the strike price and by a predetermined date outlined in the contract called the expiration date.

A put option gives the holder the right to sell the stock at the preset price and date outlined in the contract. There's an upfront cost to an option called the option premium.

The risk-reward equation is often thought to be the basis for investment philosophy and derivatives can be used to either mitigate risk hedging , or they can be used for speculation where the level of risk versus reward would be considered.

Derivatives used as a hedge allow the risks associated with the underlying asset's price to be transferred between the parties involved in the contract. Some derivatives are traded on national securities exchanges and are regulated by the U. Other derivatives are traded over-the-counter OTC , which involve individually negotiated agreements between parties. Most derivatives are traded on exchanges.

Commodity futures, for example, trade on a futures exchange , which is a marketplace in which various commodities are bought and sold. The CFTC regulates the futures markets and is a federal agency that is charged with regulating the markets so that the markets function in a fair manner. The oversight can include preventing fraud, abusive trading practices, and regulating brokerage firms.

The members of these exchanges are regulated by the SEC, which monitors the markets to ensure they are functioning properly and fairly. It's important to note that regulations can vary somewhat, depending on the product and its exchange. In the currency market, for example, the trades are done via over-the-counter OTC , which is between brokers and banks versus a formal exchange. Two parties, such as a corporation and a bank, might agree to exchange a currency for another at a specific rate in the future.

Banks and brokers are regulated by the SEC. However, investors need to be aware of the risks with OTC markets since the transactions do not have a central marketplace nor the same level of regulatory oversight as those transactions done via a national exchange. A commodity futures contract is a contract to buy or sell a predetermined amount of a commodity at a preset price on a date in the future. Commodity futures are often used to hedge or protect investors and businesses from adverse movements in the price of the commodity.

For example, commodity derivatives are used by farmers and millers to provide a degree of "insurance. Although both the farmer and the miller have reduced risk by hedging, both remain exposed to the risks that prices will change. For example, while the farmer is assured of a specified price for the commodity, prices could rise due to, for instance, a shortage because of weather-related events and the farmer will end up losing any additional income that could have been earned.

Likewise, prices for the commodity could drop, and the miller will have to pay more for the commodity than he otherwise would have. Let's use the story of a fictional farm to explore the mechanics of several varieties of derivatives. Gail, the owner of Healthy Hen Farms, is worried about the recent fluctuations in chicken prices or volatility within the chicken market due to reports of bird flu. Gail wants to protect her business against another spell of bad news.

So she meets with an investor who enters into a futures contract with her. By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.

It's important to remember that when companies hedge, they're not speculating on the price of the commodity. Instead, the hedge is merely a way for each party to manage risk. Each party has their profit or margin built into their price, and the hedge helps to protect those profits from being eliminated by market moves in the price of the commodity.

Whether the price of the commodity moves higher or lower than the futures contract price by expiry, both parties hedged their profits on the transaction by entering into the contract with each other. Derivatives can also be used with interest-rate products. Interest rate derivatives are most often used to hedge against interest rate risk. Interest rate risk can occur when a change in interest rates causes the value of the underlying asset's price to change.

Loans, for example, can be issued as fixed-rate loans, same interest rate through the life of the loan , while others might be issued as variable-rate loans, meaning the rate fluctuates based on interest rates in the market. Some companies might want their loans switched from a variable rate to a fixed rate. For example, if a company has a really low rate, they might want to lock it in to protect them in case rates rise in the future.

Other companies might have debt with a high fixed-rate versus the current market and want to switch or swap that fixed-rate for the current, lower variable rate in the market. The exchange can be done via an interest-rate swap in which the two parties exchange their payments so that one party receives the floating rate and the other party the fixed rate.

Continuing our example of Healthy Hen Farms, let's say that Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and wants to open her own processing plant. She tries to get more financing, but the lender , Lenny, rejects her. Lenny's reason for denying financing is that Gail financed her takeovers of the other farms through a massive variable-rate loan, and Lenny is worried that if interest rates rise, she won't be able to pay her debts.

He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate loan. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase, too.

Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail's, and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future. For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans. They work out a deal in which Gail's payments go toward Sam's loan, and his payments go toward Gail's loan. Although the names on the loans haven't changed, their contract allows them both to get the type of loan they want.

The transaction is a bit risky for both of them because if one of them defaults or goes bankrupt , the other will be snapped back into their old loan, which may require payment for which either Gail or Sam may be unprepared.

However, it allows them to modify their loans to meet their individual needs. A credit derivative is a contract between two parties and allows a creditor or lender to transfer the risk of default to a third party. The contract transfers the credit risk that the borrower might not pay back the loan.

However, the loan remains on the lender's books, but the risk is transferred to another party. Lenders, such as banks, use credit derivatives to remove or reduce the risk of loan defaults from their overall loan portfolio and in exchange, pay an upfront fee, called a premium. Lenny, Gail's banker, ponies up the additional capital at a favorable interest rate and Gail goes away happy. Lenny is pleased as well because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in their businesses.

To make matters worse, Lenny's friend Dale comes to him asking for money to start his own film company. Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he's kicking himself for loaning all of his capital to Gail. Fortunately for Lenny, derivatives offer another solution.

Lenny spins Gail's loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his capital back and can issue it out again to his friend Dale.

Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity. Gail and Sam are both looking forward to retirement. Over the years, Sam bought quite a few shares of HEN. But if the stock falls, you can exercise the option and sell the stock—for the older, higher price you locked in with the option. So this will mitigate the hit you took on the shares dropping.

As an investor, you naturally buy stocks you think will appreciate. But a put option is essentially a bet that share prices will fall. By hedging and buying this option, you were in a sense working against yourself—but you were also covering yourself, and shielding against an overall loss in your investments. Hedging, speculation, and arbitrage all are fairly sophisticated, and usually short-term, investment strategies.

Speculation is a trading strategy that often involves very quick-paced buying and selling. It's based on hunches, educated guesses, or theories on price moves—as opposed to fundamentals—about the financial asset or investment. As such, the timing of entry and exit is crucial. Designed to achieve fast profits, speculation involves a significant amount of risk. Hedging is investing with the intention of reducing the risk of adverse price movements in an asset.

A hedge consists of taking an offsetting or opposite position in a security that is the same as, or related to, the one the investor already has. It's a defensive move, designed to limit loss. Arbitrage is a form of hedging. It also involves making seemingly contradictory investment moves—specifically the simultaneous buying and selling of an asset or equivalent assets , often in different markets or exchanges, in order to profit from small variations in price.

Primarily used by large, institutional investors and hedge funds, arbitrage involves low risk, if executed carefully and precisely. Hedging and derivatives are actually two different animals. Hedging is an investment technique or strategy. Derivatives are investment instruments—a type of asset class. The two are related, though, in that hedging strategies—which aim to insure against overall loss—often use certain kinds of derivatives, especially options and futures contracts.

Investing Essentials. Trading Instruments. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads.

Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Special Considerations. Hedging vs. Speculation FAQs. Speculation: An Overview Hedging and speculation refer to strategic activities relating to investing, and speculators and hedgers describe traders and investors of a particular sort.

Key Takeaways Hedging and speculation are two types of investment strategies. Hedging attempts to eliminate the volatility associated with the price of an asset by taking offsetting positions—that is, contrary to positions the investor currently has. Speculation concerns attempting to make a profit from a security's price change and is more vulnerable to market fluctuations. Hedgers are seen as risk-averse and speculators as risk-lovers.

Hedging and diversification are different techniques, though both involve counter-balancing and seek to mitigate risk. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Investing Essentials Speculation vs. Gambling: What's the Difference? Partner Links.

Related Terms Hedge A hedge is a type of investment that is intended to reduce the risk of adverse price movements in an asset. De-hedge De-hedge refers to the process of taking off positions that were put in place as a hedge. What Is a Derivative? A derivative is a securitized contract whose value is dependent upon one or more underlying assets.

Its price is determined by fluctuations in that asset.