A derivative is a financial contract that gets its value, risk and basic term structure from an underlying asset. Options comprise one category of derivatives while other types include futures contracts, swaps and forward contracts. Derivatives have been used to hedge risk and increase returns for generations, especially in the agricultural industry, where one party agrees to sell crops or livestock to a counter-party who agrees to buy those crops or livestock for a specific price on a specific date. These bilateral contracts were revolutionary when first introduced, replacing oral agreements and the simple handshake.
An equity option is a derivative that obtains its value from an underlying stock.. An equity option represents the right, but not the obligation, to buy or sell a stock at a certain price, known as the strike price, on or before an expiration date. If the option is exercised by the holder, the seller of the option must deliver 100 shares of the underlying stock per contract to the buyer. Equity options are traded on exchanges and settled through centralized clearing houses, providing transparency and liquidity, two critical factors when traders or investors take derivatives exposure.
American-style options can be exercised at any point up until the expiration date while European-style options can only be exercised on the day it is set to expire. Most equity and exchange traded funds (ETFs) options on exchanges are American options while just a few broad-based.indices, including the SP-100 Large Cap Index, have American-style options. Major benchmarks, including the SP-500, have actively traded European-style options.
Other Types of Derivatives
Futures contracts are derivatives that obtain their value from an underlying cash commodity or index. A standard corn futures contract represents 5,000 bushels of corn, while a standard crude oil futures contract represents 1,000 barrels of oil. There are futures contracts on assets as diverse as currencies and the weather.
A swap is a financial agreement among parties to exchange a sequence of cash flows for a defined amount of time. Interest rate swaps and currency swaps are common types of swap agreements. Swaps are generally traded over the counter but are slowly moving to centralized exchanges. The financial crisis of 2008 led to new financial regulations such as the Dodd-Frank Act, which created new swaps exchanges to encourage centralized trading.
There are multiple reasons why investors and corporations trade swap derivatives. The most common include:
- A change in investment objectives or repayment scenarios.
- A perceived financial benefit in switching to newly available or alternative cash flows.
- The need to hedge or reduce risk generated by a floating rate loan repayment.
A forward contract is an agreement to trade an asset, often currencies, at a future time and date for a specified price. Forward contracts are traded over the counter since they are custom agreements between two parties. Due to the over the counter transactions, there is a higher risk of counterparty default. As a result, forward contracts are not as easily available to retail traders and investors as futures contracts.