What is a Derivative?
A derivative is basically a financial instrument whose value is derived from the value of an underlying security. Examples of derivatives include:
- Options - A privilege sold by one party to another offering the holder the right, but not the obligation, to buy (call) or sell (put) a security at the strike price at a certain time.
- Futures contracts - A financial contract that obligates the buyer to purchase (or in the case of a seller, to sell and deliver) the assets underlying the contract at a certain future date. Since they trade within secondary markets, the contracts are standardized.
- Forward contracts - A cash market transaction where the delivery of the asset underlying the contract is deferred until a future date. Contracts are not standardized, as they are an agreement between two parties.
- Swaps - The exchange of one security, currency or interest rate for another.
- Collateralized mortgage obligations (CMOs) - A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. Bonds are retired (from repayments from the pass-through pool) in the order specified on their prospectus.
- Rights - A security that gives shareholders the right to purchase new shares from the company at a specific price, in proportion to the number of shares held.
- Warrants - Derivatives often attached to bond issues as a sweetener. Warrants give the holder the right to purchase securities - usually stock -- at a specific price within a certain period of time that is longer than the timeframe on options or rights.
The most commonly used derivatives are options. If you are not familiar with options trading, you can read more in the tutorial Options Basics.
Options are classified as either puts or calls. When you purchase an option, you pay a premium to the option writer. Options are complex securities that can carry significant risks.
- Buying a call gives you the right to buy a stock from the writer at a specific price during a specific period of time, while buying a put gives you the right to sell the stock to the writer.
- You would purchase a call if you expect the market price of the stock to rise and purchase a put if you expect the price to fall.
- If prices move as expected, you would then profit by buying the stock at a below-market price, or selling it above the market price.
- A call is similar to a long position in a stock, increasing in value as the stock's price rises. A put is similar to a short position that gains value as the stock's price declines.
The motivation to sell (write) options is to earn the premium. Most investors who sell options hope the purchaser will not exercise those rights. The safest form of option writing is a covered call because the worst outcome would be to have shares already owned called away. A much riskier choice is selling naked options.
A naked option is an option for which the buyer or seller has no underlying position in the stock. A writer of a naked call option does not own the stock on which the call has been written. Therefore, if the stock rises and the holder of the call decides to exercise the option, the writer of the naked call will have to buy the stock at the higher price and sell it at a loss to the option holder.
Example: An option writer sells a naked call option at $25 a share of ABC Technology Inc. without owning the shares. ABC's stock then rises to $32 a share, and the option buyer decides to exercise the option. That forces the writer to buy the shares at $32 each and then sell them to the option holder at $25 - a loss of $7 a share. If the option writer had owned the shares prior to selling the option, he or she could have just turned over those shares to the option buyer.
The writer of a naked put option that does not own a short position in the underlying stock faces the same risk.
Exam Tips and Tricks
Consider this sample exam question about options:
- A client sells a right to buy 100 shares of XYZ stock at $50 three months from now. The client is a:
- Holder of a put option
- Writer of a put option
- Holder of a call option
- Writer of a call option
The correct answer is "D" - the client has written a call option.
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