A derivative is a type of security in which the price of the security is dependent on one or more underlying assets. 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; he is bullish on the stock and believes the stock's price will increase. Therefore, he has the right to buy the underlying stock. Since he is a long call holder, his 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 he sells, or writes, a call. Since he sold a call option, 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.

  1. What is the difference between derivatives and options?

    Learn how options are one type of derivative and how equity options derive their value from a stock, and understand other ... Read Answer >>
  2. What kinds of derivatives are traded on an exchange?

    Learn about the different types of derivatives traded on exchanges, including options and futures contracts, and discover ... Read Answer >>
  3. What expiry months are typically available for derivatives?

    Discover more about the derivatives market and learn about the varying expiration months for derivatives in different financial ... Read Answer >>
  4. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
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