Understanding Why Derivatives Are a Good Thing for Your Investments

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While derivatives have been much maligned of late, these complex instruments actually provide significant benefits to your investment portfolio. From active traders to buy and hold investors, nearly every market participant benefits from the widespread use of derivatives – whether they know it or not. Here’s everything you need to know about how derivatives are a good thing for your investments.

Like it or not, computers programs have filled most of the human roles on the trading floor at the financial exchanges around the world. They’re really to blame for the majority of the unreasonable price action we’ve been seeing lately – not derivatives.

While the electronic markets provide instant access to opportunities that were largely unavailable before, there are trade offs as witnessed by the recent extreme volatility. Program trading doesn’t really “think” it wants to sell, it just does.

The independence of trading for yourself and not having to make a market gives you great flexibility but it also harbors the constant uncertainty of what the next day may bring. A May 6th Squawk Box recording in the S&P 500 futures pit showed the power of the computer selling machines – as mere seconds passed, the deluge of sells in the side by side electronic mini futures was enlightening to say the least.

S&P 500 futures contracts, much like all futures contracts, are used to insure and protect portfolios – it’s more or less a broad based liquid equity basket to measure the stock market in the United States. For financial institutions, insurance companies investments, and hedge funds this is the vehicle of choice to hedge and sometimes speculate for profits.

Derivatives, often misunderstood and unfairly maligned, provide crucial functions that would make the markets a much more dangerous place without them. The price discovery process at an exchange brings together the buyers and sellers to find an equilibrium trading level. By doing so the true value is determined daily, hourly, or second by second with these two party interactions.

The financial crisis and housing bust were not because of derivatives but rather the result of Over The Counter (OTC) transactions that were mispricing assets on accounting ledgers. The private party swaps sales were worth whatever Lehman Bros. (or any other investment bank) thought they were, although obviously disastrously incorrect. Without daily mark-to-market updates it was impossible to price the unique illiquid creations. The illusion of asset worth on the books was the problem, not the derivatives themselves.

In comparison Exchange traded derivatives like equity options or futures contracts provide price transparency and a counter party to guarantee the transaction. It should be noted that the Clearing Corporation has NEVER had a default on a trade and provides confidence in every buy and sell. The easy access to current bid and ask data leaves little mystery to any positions worth. Exchange traded derivatives provide the light to disinfect any mistaken value analysis.

Current technology lets us know the price of crude oil nearly 24 hours a day – giving traders the ability to value any portfolio position short or long. It is also possible to determine what a January 2012 Crude $80 Call is worth to a high degree of certainty for an expiration date over 18 months away.

Shifting Price Risk

Another main function of derivatives is the transfer of risk. A farmer can lock in the sale price of grain by selling a futures contract for the upcoming harvest. That price hopefully ensures a profitable season by offsetting the risk of lower prices in the cash market when the product is ready for sale. It’s the perfect hedge, what is lost in selling the physical grain is made up by the gain on the futures contracts.

This ability to shift risk is indispensable when running any business so that costs can be fixed — and therefore easier to forecast.

The use of these instruments, whose price is a function of an underlying asset, has grown exponentially as businesses and trading firms use them to protect the bottom line. In fact, if you own shares of any major American company, chances are derivatives are put into play in some way for their business. And you can bet that derivatives continue to be exceedingly popular if only because they are a business necessity for everyone from corn farmers to the airlines.

It all comes back to commodities,