What are Derivatives?

When considering derivative products there are some important things to consider. Here are the basics on what are derivatives and how the different types work.

0
243

Derivatives are contracts which give a contract holder the right to buy a security or other financial product at a certain price by a certain date. The contracts are called derivatives because their value is derived from something else. Without that underlying asset, the derivative is essentially worthless. Derivatives are commonly based on stocks, bonds, commodities, interest rates, currencies, and market indexes. The value of a derivative moves up or down depending on the price of the product. For example, the value of a derivative for a share of stock would go up if the price of that stock goes up. Conversely, the value of the derivative goes down if the price of the stock goes down.

Types of derivatives include futures contracts, forward contracts, stock options and swaps.

Options

An option is a contract that gives the buyer the right to buy or sell an asset at a specific price by a certain date. The option gives the investor the right to buy, but the investor isn’t obligated to buy. The investor doesn’t have to take any action before the option expires and upon expiration, the option is no longer valuable. However, the investor loses the money used to purchase the option.

A call option gives the buyer the right to buy an asset at a specific price – called the strike price – within a specific time period. You might buy a call option if you think the price of the asset will increase within the time period. The call option is said to be “in the money” if the share price is above the strike price. On the other hand, a put option would give you the right to sell an asset at a specific price – also called the strike price – within a certain period of time. You might buy this type of option if you think the price would drop within a certain period of time. A put option is “in the money” if the share price is below the strike
price.

Futures

Futures are contracts to buy or sell stocks, bonds, or commodities at a specific price at a specific time in the future. Taking the long position on a futures contract means you have agreed to purchase the stock once the contract expires. Short position means you’ve agreed to sell the stock when the contract expires. You go long if you believe the stock price will be higher in the future than it is today and you go short if you believe the price will be lower than today.

There are hedges and speculators in both long and short futures trading. Hedgers want to “hedge” themselves against price risks. For example, a farmer selling corn crop wants to hedge themselves against lower corn prices. On the other hand, a canned goods manufacturer who purchases corn for canning wants to hedge against higher prices. Speculators want to want to profit from price changes and seek long and short positions based on the anticipation of rising or falling prices. A speculator would take a short position hoping for a lower price in the future and a long position hoping for a higher price. A hedger would do the same, except to protect themselves against declining or rising prices.

Forward Contract

A forward contract is similar to a futures contract, except that a forward contract specifies delivery of a commodity at a future date. Forward contracts are not as standardized as futures and are often made between two private parties.

Swap

A credit default swap is an agreement between private parties to exchange payment streams for a period of time on settlement dates, often to exchange a variable interest rate for a fixed one.

Futures investing involves risk and is not suitable for all investors. It is possible for an futures investor to lose the entire amount committed to options in a relatively short period of time. Copies of the Options Disclosure Document are available upon request by calling your representative or by contacting the Options Clearing Corporation at 1-800-678-4667. You may also visit their website: www.theocc.com.