What are Derivatives?
Commodities are traded in futures contracts.
Corn futures. for example, were originally created to hedge the risk of farmers from an adverse drop in corn prices. They could sell corn futures contracts (derivatives) to lock in a price of their corn crop that will be brought to market once it is harvested. Once the price is locked in, they forgo a windfall of profits if corn prices rise sharply, but they no longer risk losing their farm if prices fall sharply.
Derivatives are often highly leveraged, which is an ideal security for many speculators.
They can make large gains off a small movement in price, but they also have great risk if the price moves sharply against them. Speculators add liquidity to the derivatives markets and derivatives would likely be less useful without speculators. Investors can typically have leverage of 20
to 1 with the use of derivatives.
From the futures and option markets, derivatives have evolved into the creation of many very complex financial instruments. Derivatives were created during the housing boom for speculative and hedging (insurance) purposes.
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Many of these derivatives were unregulated and not traded on an exchange. These derivatives obviously created a great deal of problems and gave derivatives a bad name.
On the whole, derivatives are a great investment vehicle if regulated and traded properly. Hedgers can control their risk with the use of a small amount of money down. Investors or speculators have the ability to participate in a wide variety of investments through the use of derivatives that wouldn’t otherwise be feasible. Those who use derivatives properly often benefit and those who don’t will often create problems for themselves and others.Source: commodities.about.com