We've established that a key attribute of derivatives is their ability to facilitate the trading of risk associated with an underlying asset without necessitating the trading of the asset itself.
This capability translates into several compelling advantages we compared with direct positions in the underlying asset. Let's explore some of these more impactful benefits.
Foremost, amongst these is the heightened ability and the breadth of choice derivatives offer to market participants. Embedded leverage is a prime example of this flexibility in action. Considering again, our forward contract for WTI Oil, the trader agrees to purchase 10,000 barrels with settlement due in three months. Trading futures or forwards can result in an initial cash outlay referred to as margin, but it's worth noting that the initial capital outlay for entering into a derivatives position is often just a fraction of the notional value of the underlying asset of $765,000. In our case, by way of indication for such a trade, the margin might be only around $70,000, which implies approximately a tenfold leverage factor.
When trading with speculative intent, such leverage can amplify potential returns significantly. Another facet of derivatives is the streamlined process they offer for establishing short positions. These are positions which make gains when asset prices fall. If our trader aimed to bet against WTI prices in the absence of derivatives, shorting the physical commodity could be impractical, if not impossible, even when it's feasible to borrow stocks or bonds for short selling derivatives provide a more convenient route since they negate the need for complex security lending arrangements.
But the benefits extend beyond these points.
Derivatives enable the isolation and management of specific risks inherent to an asset. Take, for instance, a fixed coupon corporate bond. Its value fluctuates with interest rate movements and the issuer's credit worthiness. Should an investor wish to speculate on the issuer's credit risk in isolation while avoiding interest rate risk, they could pair their bond purchase with a derivative strategy that hedges away the interest rate risk exposure on the bond. In certain scenarios, derivatives can offer cost efficient hedging alternatives. Imagine an investor with 100 million dollars stake in total across a representative 70 stocks from the S&P 500, anticipating a short term market dip. Liquidating their positions across the 70 companies in the portfolio could be cumbersome and costly, as would be reinvesting the money once the investor believed the dip to be over. Instead, employing a short position in S&P 500 futures could consolidate this hedging action into a single more cost effective transaction. Lastly, it's important to highlight that derivatives facilitate the crafting of more complex trading strategies.
These strategies typically involve options and can include positions that capitalize on volatility, benefiting from significant price movements regardless of the direction of the underlying asset. In conclusion, derivatives offer versatile tool offering strategic benefits such as leverage, simplified short selling risk, isolation, cost effective hedging, and the ability to design nuanced trading strategies.
