What are derivatives, and how did they come to be? Those two questions are often on the minds of new and experienced investors. Unfortunately, the second part of the query is where most draw a blank. They might be able to buy and sell options, futures, CFDs (contracts for difference) and warrants. However, they don’t have a clue about the history of the instruments.
While historical trivia might not help your bottom line as a trader or investor, it’s helpful to know the origins of the three most common derivatives. Whenever two or more people or entities enter into a contract whose worth is determined by the price of an underlying, specified asset, that’s a derivative-style transaction. Note the word underlying in the definition. Derivatives are one step removed from the direct trading of assets. Hence contract values are derived from whatever that asset happens to be, whether it’s a stock, bond, commodity or something else. Here are the three most popular in existence, with details about their work and histories.
CFDs (Contracts for Difference)
One of the most popular ways to play the market is with contracts for difference, a newer form of derivative. The difference between opening and closing prices is settled in cash. Holders do not take any ownership in the underlying security or asset class. Instead, CFD trading generates a profit if the holder correctly predicts price movement direction. When they first appeared in the 1990s, CFDs were only traded in London, and all transactions were done within margin accounts. The inventors of these unique, simple contracts were two men named Wood and Keelan of the company, UBS Warburg.
Options are among the most heavily traded financial instruments in the world. In their simplest form, each option gives the owners the right to either sell or buy a fixed number (typically 100) of shares of stock for an agreed-upon price on a selected date in the future. Owners can exercise their rights before the expiration date if they wish.
One of the many myths about the stock market is that some people assume that options are relatively modern instruments, but they are thousands of years old. Their first use was in ancient Greece, where farmers and investors figured out a way to speculate on future olive crops. There was no formal exchange, and not many contracts were traded. Since then, dozens of cultures have come up with ways of handling these arrangements. In 1973, the first modern options marketplace was the CBOE, Chicago Board Options Exchange.
While it is true that cash is king, if you buy or sell any financial instrument or asset at a fixed price to be settled on a date in the future, you’ve engaged in a futures contract. These kinds of contracts, so popular among experienced and institutional traders, have been around in crude forms for more than 1,000 years. However, the first verified existence of an organized futures exchange was in 1730 in Japan, among the country’s rice traders. But even before that, individuals had been trading in this way since the 1500s in England. Later, the West developed its exchange in 1877 when London organizers opened a metals and market trading center.