A derivative is a financial security that is used by investors to speculate on the direction of a market. The name derivative is used to describe a security in which the value is derived from another security. For example, a stock derivative would attain some of its value from the price of a specific stock. These types of financial instruments are contracts between two parties and are priced based on changes in market sentiment. An option is one type of derivative.
Derivative Basics
A derivative is a contract that is traded on an exchange, such as the Chicago Mercantile Exchange, or over the counter. For example, a futures contract on crude oil is traded on the New York Mercantile Exchange and is valued based on the price of spot crude oil. Futures contracts between two parties for the sale of sell an asset on a specified future date. They are generally traded on exchanges, but they may also be traded in the over-the-counter market.
Option Basics
An option is the right -- but not the obligation -- to purchase or sell a security, such as a stock, at a specific price, on or before a certain date. Stock options are derivatives contracts, the prices of which fluctuate based on the movement of the underlying stock price. Options are unique derivatives in that they are only valid for a specific period of time. The date when an option expires is referred to as the expiration date, while the price at which the stock can be purchased or sold is the strike price.
Derivatives versus Options
In a nutshell, options are derivatives, but derivatives are not necessarily options. Derivatives securities include options, futures, swaps and forward contracts. They are used to describe a broad range of securities while options have a narrower definition. Most derivative securities allow investors to use leverage, which allows investors to borrow capital to purchase derivatives. This can enhance returns, but it also increases the risk of substantial losses.
Pros and Cons of Options
One of the key components of an option that distinguishes it from other derivatives is that the buyer stands to lose only the premium paid to purchase the option. For example, if an investor pays $5 for the option to purchase a share of a particular stock currently priced at $8 at a strike price of $10 and the share price fails to reach the strike price by the expiration date, he loses only the $5 paid for the option. The seller, on the other hand, can face significantly more risk. If an option to purchase stock when the share price reaches $10 is sold for $5 and the price of the stock soars from $8 to $20, the seller has lost the opportunity for much higher profit on the sale of the share. He is obligated to sell it for $10 rather than $20.
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Writer Bio
David Becker is a finance writer and consultant in Great Neck, N.Y. With more than 20 years of experience in trading, he runs a consulting business that focuses on energy hedging and capital market analysis. Becker holds a B.A. in economics.