Simply put, derivatives provide investors with the opportunity to buy or sell the option on a security. Since the investor does not buy the actual asset, he or she speculates in agreement with another party on how the price of the asset will fluctuate. Derivatives traditionally come from energy products that trade on the stock exchange. These products, which include natural gas, electricity, and oil, yield derivatives as swaps, options, future contracts, or forward contracts. The value of derivatives varies according to a product’s changes in price. Exchange-traded funds, often set up for energy products, are structured like commodity pools, from which shares are issued. Derivatives serve specific purposes in portfolios, such as providing a hedge position, speculating on a product’s movement, and increasing leverage. Since investors are betting on the performance of an asset, large gains can be realized for low prices if the market changes the way an investor predicts.
The array of financial strategies available today has resulted in many complicated choices when putting together a portfolio. Derivatives serve as a way for investors to diversify a portfolio, as long as the investor fully comprehends the risks involved and the impact this type of investment can have.