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Why buy derivatives?

There are two main reasons for buying derivatives: speculation and hedging. Some securities, like contracts for difference, can also offer investors a way to trade in assets without the need to physically own that asset – for example, you can buy or sell the price of crude oil, without having to make room in your garage for all those barrels!

Many institutional investors include a number of derivative financial instruments in their portfolios. They don’t tend up make up the core of a portfolio, these are typically safer assets, such as government bonds, which are there to provide a secure, albeit low-yielding annual income.

Instead, derivative contracts are seen as so-called ‘satellite holdings’ – things that investors can have a bit of a gamble with to try and make bigger, or higher-yield, returns. This is speculation.

Investment derivatives can be used to offset some of the risk already present in a portfolio – and this is called hedging. For example, if a portfolio contains corporate bonds, credit default swaps can be used as insurance against default on those bonds.

There are many other examples of hedging, but let’s come back to that – and look now at some of the different types of derivative in a bit more detail. First, let’s examine some of the more common products that are easier to trade and understand.

Test yourself

What are the two main reason for buying derivatives?

Dividends and hedging
All answers provided are correct
Speculation and hedging
Speculation and dividends
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Do you know your CFDs from your IPOs or ETFs? Remove the mystery with our definitions glossary.

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Term of the day

Net Asset Value (NAV)

It's a way to measure the value of a fund. It takes into account the number of shares outstanding in the fund and its liabilities. It's used particularly to measure the assets of a mutual fund or exchange-traded fund. Where have you heard...

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The most common word

Market Order

A market order is an order to buy or sell a financial instrument immediately at the best available current market price. These are completed as long as there are willing buyers and sellers. They tend to be used when the most important factor in...

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