A Look at Derivatives and Precious Metals

While options and futures get the most attention, there are other kinds of derivatives out there too. Derivatives can be based on anything from stocks and commodities to interest rates, currencies and even the weather. Some derivatives are even based off of other derivatives.

Derivatives can trade on a lot of different exchanges , from traditional markets like the American Stock Exchange (AMEX ) to special exchanges designed specifically for a particular type of derivative like the Chicago Board Options Exchange (CBOE ). Many derivatives also trade over-the-counter (OTC ).

Why Would You Use Derivatives?

One of the simplest uses for derivatives is to hedge (or limit the risk in) the investments you currently hold (see "Finance Professor: Five Hedging Techniques You Must Know"). If you are short a stock, an option to buy that same stock at a low price could protect you from serious losses if its share price increases.

Hedging through derivatives is often used by huge companies on a very large scale. You wouldn't necessarily expect to find traders working at an airline, would you? JetBlue(JBLU) has benefited immensely from its use of oil futures to hedge against recent unfavorable prices of one of its biggest expenses, jet fuel. Many industries wouldn't survive without derivatives as a hedging tool.

Derivatives are also used by more seasoned investors as speculative investments. One of the benefits of trading derivatives is the fact that you don't necessarily need to deal with taking physical possession of 10 barrels of crude oil or deal with the banking conundrum that presents itself when you've just bought 20 million Yen (Japanese currency ) because your futures hit their settlement date . And while the upside to speculating with derivatives can be fantastic, dealing with this kind of investment can be complex enough that it should probably be avoided by all but those who know what they're doing.