A derivative is a financial instrument—or, simply put, a contractual agreement between two parties—that has a value, based on the expected future price movements of the "underlying asset" to which it is linked. The underlying asset can be a stock, bond, currency or commodity. Strictly speaking, a derivative has no value of its own. It is not an asset; it is a contract. There are myriad kinds of derivatives; the most common are options and futures.
Let's examine the two most common examples of a derivative: options and futures.
An option is a binding, specifically worded contract that gives its owner the right to buy or sell an underlying asset at a specific price, on or before a certain date. The investor has the right—but not the obligation—to buy.
The right, but not the obligation, to take action is a key distinction. Upon the expiration date, you could always decide to take no action, at which point the option becomes worthless. If you make this decision, the option becomes worthless and you lose all of your investment, which is the money that you used to buy the option.
An option is only a contract that's tied to an underlying asset (such as, say, a stock or stock market index). Hence, it is categorized as a "derivative," because an option derives its value from something else. Derivatives have acquired a pejorative reputation of late, because incredibly complex derivatives helped fuel the financial calamities of 2008.
Options come in two flavors: calls and puts.
If you think a certain asset will increase substantially before the option expires, you'd purchase a call option, because it gives you the right to buy an underlying asset at a specific price within a specific period of time.
If you think a stock will dramatically drop in value, you'd purchase a put, which would give you the right to sell the asset at a certain price within a specific period of time. Think of a put option as a form of leveraged short selling.
Accordingly, there are four types of players in options markets: buyers of calls; sellers of calls; buyers of puts; sellers of puts. The "strike price" is the price at which an underlying asset can be purchased or sold. For calls, this is the price at which an asset must rise above; for puts, it's the price at which it must go below. These events must occur prior to the expiration date.
A "listed option" is traded on a nationwide options exchange, such as the Chicago Board Options Exchange (CBOE). These options are listed with fixed strike prices and expiration dates. The options are named based on their strike price and expiration date. For example, an ADSK January 45 Call is a call option on Autodesk stock at $45 per share that expires in January.
Call options are referred to as "in the money" if the share price is above the strike price. Put options are "in the money" when the share price is below the strike price.
Futures are contracts to buy or sell stocks or bonds, or commodities, at a stated price at a stated time in the future. These commodities include pork bellies, gold, currency, corn, wheat, orange juice, etc.
Most commodity futures contracts come due within three or six months. You can buy and sell single stock futures or stock index futures, which are contracts based on the performance of a broad index such as the Standard & Poor's 500.
When you purchase or sell a stock future, you're not buying or selling the underlying stock. You never really own the stock. You're engaging in a futures contract, which is an agreement to buy or sell the stock certificate on a certain date at a fixed price.
A futures contract essentially entails one of two positions: long or short.
If you've entered into a long position, you've agreed to purchase the stock when the contract expires. A short position stipulates the inverse: you've agreed to sell the stock when the contract expires. So, if you're convinced that the price of your stock will be higher in three months than it is today, you take a long position. If you think the stock price will be lower in three months, you choose to go short.
Futures contracts are traded in freewheeling "trading pits" at exchanges worldwide. It's in these frenetic environments where traders determine futures prices, which change from moment to moment. Established in 1848, the Chicago Board of Trade (CBOT) is the world's oldest futures and options exchange. More than 3,600 CBOT members trade in excess of 50 different futures and options contracts.
Most commodity and currency futures have a margin of 5%, which means to make a trade, you only have to put up 5% of the contract value. That's a small stake, because prices can easily and quickly move by much more than 5% in only a day's time.
However, a leveraged bet of 5% is much smaller than the margin debt with which you're allowed to buy stocks. A percentage that small doesn’t allow you to ride out ephemeral fluctuations. It's possible to bet hideously wrong.
As with options, a futures contract uses leverage that can turn a small bet into a very large win or loss. In fact, futures are even riskier than options, because with the latter, an options buyer's worst-case scenario is losing the original investment. An investor in the futures market can lose a lot more. Then again, a single futures contract can rise in value by several thousands of dollars each day.
Why Derivatives Matter:
The overriding point is this: Investors can wield significant leverage in derivatives. A small or modest bet can pay off with a huge win—if you're right. Derivatives allow investors to control a large amount of money with a relatively small stake.
Derivatives and other options trades are discussed and recommended in Cabot Options Trader.