You might have heard this term before and wondered what in a derivative? It is a complicated sounding word but really isn’t a complicated concept. The definition of this word is very simple and it will make more sense if I start off with the definition straight from the Merriam-Webster Dictionary:
Derivative: Something that comes from something else : A substance that is made from another substance
Like the definition states any investment that is based on something else is considered a derivative; however, in the investment world, these are normally contracts to buy or sell another asset such as stocks, bonds, ETF’s. This can be hard assets as well such as cattle, gold, or oil which sell on the commodities and futures market. Each derivative has three things in common.
They are a contract to buy, sell or receive an asset.
They have an expiration date.
The contracts have a set of terms.
For this introduction, I will use stock options as an example because they are the simplest way to explain this investment type. Most people understand the stock market more than the other types of investments; however, there are two really important terms that you should know before you read any further, so you can better comprehend what I am talking about. Learn the difference between going long and short in the market.
When someone takes a long position in the stock market that means they are buying stock. With a long position, you want the value of the stock that is purchased to go up in value to make a profit. This is the strategy that most beginner investors will choose because it is less risky than a short position.
Going short is something that is not recommended to the beginner trader. What this means is that the trader is selling stock at the current market price and will replace it at another time. With this strategy, the trader wants the stock to lose value to make a profit.
One of the most popular types of derivative contracts that individuals trade are called stock options. These are contracts that give the owner of the contract the “option” to buy or sell stock at a set price. When you purchase a stock option you aren’t actually purchasing the asset portion of the contract which would be the stock; instead, you are buying a contract to buy or sell the stock options within a given time-frame. There are two sides of each contract which I explain below.
If you buy a call option, you will want the underlying asset to increase in value. Think of this like buying or going long on the stock if you were to buy it outright. This contract is the option to buy shares at the strike price on the contract.
With a put option, you would only make money if the underlying asset decreases in value. Think of this like shorting the market of selling shares of stock. This is the option to sell shares at the strike price.
Options Chain Example
Some Other Characteristics of Derivatives
One of the things that are different about stock options is the amount of risk they have compared to other derivatives. With options, the holder of the contract doesn’t have to call the stock and that is why it is an option. With other types of derivatives, this isn’t true. For example, the person who is holding future has to receive the goods.
How often do People Call or Put the Option?
One of the things that I should explain is many of the options never get exercised. This is because a major majority of the options are useless by their expiration date. Most of them are “out of the money” or purchased for insurance. As you can see by the example options chain, there are going to be a lot of options that are going to be worthless at the end of the call date.
In The Money vs Out of the Money
When you hear someone saying that an option is in the money or out of the money it is important to understand that this means the option has no value. As an example if we had a call option today at the 207 strike price this would mean we are out of the money. It makes no sense to buy shares at 207 when the market price is only 205.49. As you can see this is why so many options expire worthlessly.
Purchased For Insurance
One of the most popular strategies is purchasing options as insurance. This is a stratagy where the person owns stock and purcahses a put option to decrese their risk. If the price would fall or crash, the holder of the option can exercise it or sell the option to another trader. This is a common use for this type of derivitive.
For more on options, keep a watch on my blog. I will write more about this subject because it is misunderstood.