What is a Derivative? – by Conner W. Mays
In the world of financial markets, a derivative is a contract which derives its value from an underlying security or asset. I know that is an ugly sentence and that is the way Wall Street likes to say things so you remember only they can do what they do – which is false.
Put differently – a derivative contract (a derivative) is an agreement between two parties to make a decision or take an action in the future based in some set of terms and conditions – that’s it.
The vast majority of derivatives can be bucketed into four categories:
Derivatives have been coined by many as “Financial Weapons of Mass Destruction” however, when they are used properly and prudently, they can be very useful. Think of a scalpel, a scalpel is extremely sharp, if a scalpel is used improperly it can cause a great deal of harm however, in the hands of a surgeon who is using it properly and prudently, a scalpel can save your life.
This topic can be complex – but it doesn’t have to be – I will work on follow up material that goes deeper into the payoff structures and specific risks of the different types of derivatives but for today, let’s cover what these contracts are and what they actually do.
The buyer of an option has the right, but not the obligation, to buy or sell the underlying asset on or before a specified date (execution date) at a specific price (strike price.) Options come in two basic forms:
- Call Options (Calls)
- Put Options (Puts)
A call option gives the buyer of the call the right, but not the obligation, to buy the underlying. A put option gives the buy of the put the right, but not the obligation, to sell the underlying.
Options can be used to profit from increases, decreases or no change in the value of the underlying. There are a massive number of strategies that can be used to profit from virtually every price scenario. I will discuss the different scenarios in a follow up article.
There are four different ways to use an option
- Buy a call option
- Buy a put option
- Sell a call option
- Sell a put option
Selling an option is referred to as writing an option.
In contrast to options, futures are a derivative that obligate the long party (the buyer) to purchase the underlying on a specified date at a specified price – on the other side of the trade – the short party (the seller) is obligated to sell the underlying at a specified price on a specified date.
Imagine you and I were discussing the possibility of the Dow Jones Industrial Average (DJIA) hitting 21,000 by December 1st, 2017. I think is it a certainty, you don’t think there is any possible way, so you sell me a futures contract on the DJIA for 21,000 which executes on December 1st, 2017. Regardless of the value of the DJIA on December 1st, 2017 – I am buying the Index from you for 21,000.
One important characteristic here is that futures are traded on an exchange thus, they are regulated and standardized.
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