Why use derivatives?
Understanding their role in financial markets
Investors use derivatives for a variety of reasons, from managing risk to gaining exposure to a specific market. While derivatives can be used in different ways, understanding their purpose and how they work is an important first step before considering any investment strategy.
Gain exposure to a market
Derivatives allow investors to gain exposure to the performance of a market or asset without directly buying the underlying instrument.
For example, an investor may wish to take a view on government bond markets, stock indices or single stock without purchasing the underlying securities themselves.
This can provide an alternative way to participate in market movements through exchange-traded products.
Leverage
Derivatives can provide exposure to a market with a smaller initial capital commitment than buying the underlying investment directly. This is known as leverage. While this can amplify gains, it can also amplify losses, making it important to understand the risks before trading.
Express a market view
Investors may use derivatives when they have a view on how a market could perform in the future.
For example, an investor may believe:
- Bond prices could rise or fall
- Interest rates may change
- A stock index may increase or decrease in value
Derivatives can provide a way to take a position based on these expectations.
Manage risk
Derivatives are often used to help manage existing market exposures.
This is commonly referred to as hedging and involves using a derivative to help offset the impact of adverse market movements on other investments held within a portfolio. Different hedging strategies may be used depending on an investor's objectives, risk tolerance and market exposure.
Access markets efficiently
Derivatives provide access to a range of markets through standardised contracts traded on regulated exchanges.
They enable investors to access markets such as:
- Equity indices
- Fixed income markets
- Commodities
- Currencies
Understanding how these products work, including their risks and features, is essential before investing.
Important considerations
Derivatives are not suitable for all investors.
Before trading derivatives, investors should understand:
- How the product works
- The underlying market or asset
- Margin requirements
- Market risk and volatility
- Contract expiry and settlement
- Potential gains and losses
Building a strong understanding of these concepts can help investors make more informed decisions.