A derivative is a type of security in which the price of the security is dependent on one or more underlying assets. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Certain kinds of derivatives can be used for hedging, or insuring against risk on an asset. Derivatives can also be used for speculation in betting on the future price of an asset or finding a way around exchange rate issues.
Going Long or Short on a Derivative
A derivative is a contractual agreement generally between two parties. One party is short the derivative, while the other party is long the derivative. When a party buys a derivative security, it is said to be long the derivative. When a party is short a derivative, it is a seller of the derivative.
One type of derivative security is equity options. One stock option contract gives the buyer, or holder, the option of the right to buy or sell the underlying stock at a predetermined price on or before the option's expiration date. Traders and investors could be long a call or a put option and similarly they could also be short a call or a put option.
For example, assume a trader is long a call option on stock ABC. The trader is bullish on the stock and believes the stock's price will increase. Therefore, the trader has the right to buy the underlying stock. By holding the long call, the trader's payoff is positive if the price of ABC stock exceeds the predetermined strike price by more than the premium paid for the call option.
Conversely, assume a trader believes stock ABC's price will decrease and as a result sells (or writes) a call. Since the call option was sold, the long call holder has control over whether the option will be exercised. The seller of the call is obligated to deliver the shares to the long call holder if the call option is exercised.
The payoff for the seller of the call option is equal to the premium received by the buyer of the call option if the stock's price declines below the strike price. However, if the stock rises more than the strike price plus the premium, the writer loses money.