A derivative is a type of security that has a value that depends 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 the risk of 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.

Understanding Derivatives

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. Futures and options are both examples of derivatives.

Key Takeaways

  • Derivatives are contracts that have values derived from other assets like stocks, commodities, or currencies.
  • Equity options—puts and calls—are derivatives.
  • A bullish trader goes long a call option when they expect the price of the underlying stock to go up and might go short a call when they expect the price to be flat or fall.
  • A long put is bearish on the underlying and a short put expresses willingness to buy shares at the strike price.

Equity options are derivatives and come in two types: puts and calls. One stock option contract gives the buyer, or holder, the option or 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.

Going Long a Derivative

Calls and puts are long when they have been purchased as a new position. For example, assume a trader is long a call option on stock ABC because that trader is bullish on the stock and believes the stock's price will increase. By going long the call, they have the right to buy 100 shares of the underlying stock per contract. By holding the long call, the trader's payoff is positive if, through the expiration, the price of ABC stock exceeds the strike price of the call by more than the premium paid for the call option.

Now, suppose a trader is expecting the underlying stock to fall and wants to make a bearish bet. They buy a put option and are now long the put. This gives them the right to sell the stock at the strike price through the expiration.

Long puts and long calls can be closed at any time prior to the expiration by selling a contract with the same terms. So, if an investor is long 10 ABC Jan 50 calls and wants to exit the position, they sell 10 ABC Jan 50 calls to close or offset it. If so, the trader has exited the position and is neither long nor short the option. They have covered the long position and have no positions open.

Going Short a Derivative

Assume a trader believes stock ABC's price will decrease or trade flat. As a result, they sell or go short a call. Since the call option was sold, the seller or writer of the call is obligated to deliver the shares to the long call holder if the call option is exercised. On the other hand, if they expect the stock to hold above the strike price of a put or are a willing buyer of the stock at the strike price, they might sell or go short the put option.

The payoff for the seller of the put or call option is equal to the premium received for opening the position. It can be covered at prior to the expiration through an offsetting purchase. However, if the short option is assigned, it is too late to close the position. That means, the short put holder must take delivery of 100 shares per contract at the strike price and the short call holder must sell 100 shares per contract.

The Bottom Line

A derivative is a financial security whose value is tied to that of an underlying asset. Futures and options are two common examples of derivatives. Being long a derivative means an investor or trader has bought the derivative with the expectation of a price increase, whereas being short a derivative means an investor or trader is a seller of a derivative with the expectation of a price decrease.