Derivative Products (Derivatives)

Derivative Products (often shortened to just 'Derivatives') are financial contracts between two or more parties whose value is derived from an underlying asset, group of assets, or benchmark. Think of it this way: instead of buying a share of a company directly, you could buy a contract that bets on whether that share price will go up or down by a certain date. The contract itself has no intrinsic value; its worth comes entirely from the price movement of the underlying thing it’s tied to. These underlying assets can be anything from stocks, bonds, and commodities like oil and wheat, to currencies, interest rates, and entire market indexes. Derivatives were originally invented for a very sensible purpose: managing risk, a practice known as hedging. However, they are now overwhelmingly used for speculation—making highly leveraged bets on future price movements. Their complexity and capacity for creating massive, hidden risks make them a topic of great concern for value investors.

At its core, a derivative is just an agreement. Let’s use a simple, classic example: Imagine a wheat farmer who will have a crop ready in three months. She's worried the price of wheat might fall, hurting her profits. In the same town, there’s a baker who is worried the price of wheat might rise, increasing her costs. They can use a derivative to solve both their problems. They agree on a futures contract: the farmer promises to sell 1,000 bushels of wheat to the baker in three months' time for a fixed price of $5 per bushel, regardless of the market price on that day.

• If the market price of wheat drops to $4, the farmer is thrilled. She still gets to sell at $5, protecting her from the price drop. The baker has to pay more than the market rate, but she has certainty about her costs.
• If the market price of wheat soars to $6, the baker is the happy one. She gets to buy her wheat for only $5, protecting her from the price spike. The farmer misses out on the extra profit but has successfully avoided the risk of a price collapse.

Both parties used a derivative to hedge against unwanted price swings. They traded away potential upside to eliminate potential downside. The contract's value was entirely dependent on the price of the underlying asset: wheat.

While there are countless complex variations, most derivatives fall into one of four main categories.

An Options contract gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price (the 'strike price') on or before a certain date. For this right, the buyer pays a fee called a premium.

• A Call Option is the right to buy. You'd buy this if you think the price of an asset will rise.
• A Put Option is the right to sell. You'd buy this if you think the price will fall.

Think of it like putting a non-refundable deposit on a house. You've paid for the option to buy the house at an agreed-upon price, but if you change your mind, you can walk away, losing only your deposit (the premium).

Futures are the type of contract our farmer and baker used. It is a standardized contract that obligates the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. Unlike options, you don't have a choice; the transaction must happen. These are traded on exchanges, making them more transparent than some other derivatives.

Swaps are private agreements where two parties agree to exchange sequences of cash flows for a set period. The most common type is an Interest Rate Swap, where one company might swap its variable-interest-rate loan payments for a fixed-rate payment stream from another company, allowing both to better manage their liabilities. For most individual investors, these are out of reach and sight.

Forwards are like futures but are private, customized contracts between two parties. Because they aren't traded on an exchange, they are less standardized and carry greater counterparty risk—the risk that the other side of the deal will fail to pay up.

“In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” - Warren Buffett, 2002 This famous quote perfectly captures the typical value investor's skepticism. While derivatives can be used for sensible hedging, their potential for misuse and destruction is immense. Here's why value investors are wary:

• Complexity and Opacity: Derivatives can be so complex that even the people creating and trading them may not fully understand all the embedded risks. For an individual, trying to value a derivative is often a fool's errand compared to valuing a business.
• Extreme Leverage: Derivatives allow investors to control a large amount of an underlying asset with very little money down. This use of leverage magnifies both gains and losses. A small, adverse price move can wipe out an entire position, and in some cases, lead to losses far exceeding the initial investment.
• Focus on Price, Not Value: Value investing is about determining the intrinsic worth of a business and buying it for less. Speculating with derivatives is almost entirely about betting on short-term price movements and market sentiment—the polar opposite of a long-term, business-focused approach.

For the vast majority of investors, the path to wealth is paved with owning wonderful businesses for the long term. It does not require venturing into the complex and often dangerous world of derivatives.

Derivatives are sophisticated tools. In the hands of a disciplined and knowledgeable expert using them for a clear, risk-reducing purpose, they can be useful. In the hands of almost everyone else, they are instruments of speculation that can inflict devastating losses. For the prudent investor building a portfolio based on value principles, the best strategy is simple: understand what derivatives are, appreciate the risk they pose to the financial system, and leave them to the specialists. Focus your time and capital on what you can understand: great businesses.