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Join date: Nov 24, 2022

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Why do traders need derivatives?


Because derivatives can be used both for hedging risks and for speculating on changes in the price of the underlying asset.

But more often they are used for hedging, i.e. for protection against serious price movements. A precisely-written contract that requires the execution of a deal at conditions that are strictly specified at the moment is an excellent protection from any changes. As for speculation, it is when traders try to predict how the price of an underlying asset will change over time and make it more profitable to buy or sell in the future. This is quite risky - it is no accident that the famous financier Warren Buffett once called derivatives "financial weapons of mass destruction," as he held them responsible for the global financial crisis of 2007-2008.

There are many ways of using this financial instrument in real life, read here more redot derivatives. For example, before the mentioned crisis, the largest U.S. holding company Berkshire Hathaway began selling put options on four major stock indices, including the S&P 500 and FTSE 100.



What is a put option?

It is a form of derivative in which the new owner acquires the right, but not the obligation, to sell a certain underlying asset to the option seller at a certain price by a predetermined date. That is, numerous investors were given the opportunity right now to choose at what price to sell their shares in the future. And if the price of the shares had fallen by then, the investors would have won, because they would have been more than happy to sell them at the old - predetermined price. But if that price had gone up, the company would have received a net premium for the unexercised option, because no one would have been willing to sell the shares cheaper than the real market price. Berkshire Hathaway took a significant risk, but it was worth it, so the move brought the company a profit of $4.8 billion.

There is another interesting example of the use of derivatives in the aviation business. Airlines are very dependent on fuel, the cost of which fluctuates depending on oil prices and a number of other factors. Therefore, to avoid the negative impact of these fluctuations, derivatives are used for hedging. The example of Southwest Airlines, the largest U.S. low-cost carrier, which was able to effectively use this financial instrument, is well known. They managed to block the price of jet fuel at a time when the cost of oil was unusually low, so now the company pays 25-40 percent less than its competitors for refueling.

There are also examples of the use of such financial instruments that are not linked to traditional financial systems. For example, there is a whole segment of so-called "weather derivatives," which protect farmers and commodity suppliers from financial losses associated with extreme weather, such as frost, hurricanes and floods.