A:

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.

RELATED FAQS
  1. When is a put option considered to be "in the money"?

    Learn about put options, what they are, how these financial derivatives operate and when put options are considered to be ... Read Answer >>
  2. When is a call option considered to be "in the money"?

    Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >>
  3. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  4. Are ETFs considered derivatives?

    Learn why most exchange-traded funds (ETFs) are not considered derivative securities and the special circumstances when this ... Read Answer >>
Related Articles
  1. Trading

    Derivatives 101

    A derivative investment is one in which the investor does not own the underlying asset, but instead bets on the asset’s price movement with another party.
  2. Trading

    Option trading strategies: A guide for beginners

    Options offer alternative strategies for investors to profit from trading underlying securities. Learn about the four basic option strategies for beginners.
  3. Trading

    Beginners Guide To Options Strategies

    Find out four simple ways to profit from call and put options strategies.
  4. Investing

    Complex Derivatives Made Simple

    Many ETFs hold derivatives. Here's how to be sure if you own a derivatives-based ETF.
  5. Trading

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  6. Trading

    Was Buffet Right about Derivatives as WMDs?

    Why Warren Buffet described derivatives as weapons of mass destruction, and when can they be helpful or harmful?
  7. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
RELATED TERMS
  1. Equity Derivative

    A derivative instrument with underlying assets based on equity ...
  2. Exchange Traded Derivative

    An exchange traded derivative is a derivative that is standardized ...
  3. Underlying

    Underlying, in equities, refers to the common stock that must ...
  4. Economic Derivative

    Economic derivatives are contracts that allow hedgers and speculators ...
  5. Energy Derivatives

    Energy derivatives are financial instruments in which the underlying ...
  6. Derivatives Time Bomb

    Derivatives time bomb is a descriptive term for a possible market ...
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center