It would be a mistake to think that derivative products are new-fangled economic instruments. In ancient times the Phoenicians, Greeks and Romans were already drafting contracts with clauses granting options on the goods they transported in their ships. Economic history books tell that the famous Greek mathematician and astronomer Thales made a substantial killing by investing in options on olives, thanks to getting his forecast about the harvest right. In the 17th and 18th centuries in Japan futures contracts on rice were traded under a carefully worked out set of rules.

Options
The first official options market was founded in Holland at the beginning of the 18th century. The purpose of the market was to allow traders to buy and sell options on tulip bulbs (a highly prized commodity in the Netherlands) at a certain future date. A purchase option granted the holder the right to buy tulip bulbs at a previously established price -which, generally speaking, would be the market price at that moment- during a set period of time.

Burton G. Malkiel, author of the bestseller A Random Walk down Wall Street, explains how the tulip bulb options market worked: the holder of an option would pay a sum of money known as an option premium, which could vary between 15 and 20% of the current market price. For example, a purchase or call option for a tulip bulb valued at 100 florins at that moment might cost the buyer no more than around 20 florins. If the price rose to 200 florins, the holder of the call option could exercise his right to purchase; he could buy at 100 and, at the same time, sell at the then current price of 200 florins. In that moment -the date which had been previously established- he could obtain a profit of 80 florins (that is to say, the 100 florins which the price rose, less the 20 florins he paid for the option).

However, in the above case, if the price of tulips had plunged and they were selling at 50 florins, the holder of the option would not exercise his call option and would simply lose the money invested in the premium. In other words, with a purchase option it is possible to invest in the market with less risk, while getting the most out of your money.

In short, an option is the right (but not the obligation) to buy or sell something. In this type of product there are a series of requirements: the contract size should be established (100 bulbs, for example); a strike (or exercise) price (100 florins, in the case we saw above); a premium (20 florins, which was the amount the investor paid to acquire the right to buy or sell the tulips); and a maturity date (the date set when the contract was made).

When speaking about derivative products, it is useful to understand the stock market meaning of the term leverage, which investors tend to be continually dropping into their conversations. In fact, an option is a way of leveraging investments. Leveraging is any technique which allows an investor to increase the possible profits (and risk) of an investment.

Futures
Futures contracts, which were formerly used only to trade commodities such as rice, cereals, minerals or tulip bulbs, are now used to buy or sell shares on the stock market. Thus a stock futures contract is a financial instrument whereby the investor can take bullish or bearish positions in shares of Ibex-35 companies (the top 35 companies by trading volume on the Madrid Stock Market).

The attraction of futures lies in the fact that, with a smaller investment (since it isn�t necessary to pay out the full amount of the investment, just the deposit, or initial margin as it is known), you can speculate on the major securities on the market.

This type of financial product is known as a future for the obvious reason that the products which are bought or sold are not received at the time of the transaction. In other words, delivery is made at a previously established future date, known as maturity. Futures are also referred to as commodities or derivatives.

Warrants
A warrant is another financial product, akin to options and futures, by which the investor can buy shares at a price higher than they are trading at that time. Warrants give the bearer the right to acquire shares at a set price, regardless of their current trading price on the markets. Warrants are distributed by the company who originally issued the shares as an incentive to attract investors at a difficult moment for the company or when it is starting up. Since warrants are issued at a higher than market sale price, the holders of these assets differ from ordinary shareholders in that they are betting heavily on the share price rising.

Warrants may also be traded, which makes this extremely dynamic financial instrument even more attractive. Very often a warrant holder can earn more money by trading his subscription rights than by selling the underlying shares.

Upside and downside of futures

In her book Invest and Win on the Stock Market, the economist Patricia Crespo describes the positive and negative aspects surrounding futures:
� The futures market can be used as an instrument to hedge against the risk arising from of the fluctuation of spot prices before the maturity date.
� Futures contracts involve a lower initial outlay than other similar instruments, since you only have to pay a deposit or initial margin to secure an underlying asset worth much more.
� The fact that there is an organised market and standardised contractual terms provides liquidity and offers players the chance to close positions prior to maturity.
� The parties involved in the contract run no risk of insolvency since the Clearing House guarantees the contract�s liquidity.
� With futures there is a risk of misreading future trends.
� By using futures contracts as a hedging instrument an investor will lose out on potential profits if prices move favourably in the future.
� As the terms of the contract are standardised, futures contracts do not exist for every instrument or every kind of commodity, and it may be impossible to hedge every spot position.

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