There are several types of derivatives: Swaps, options, contracts and futures. These are the more common of the derivatives you’ll see at the brokerage firms and for end user, retail investors.
Different Types Of Derivatives : Options
Options are contracts that give the buyer a right, but not an obligation to buy or sell an underlying asset at a specific price (this price is known as the ‘strike price’ in the market) before or at a certain date.
Normally, options (especially for stocks and stock indexes) are traded in a lot of about a hundred stocks per option. This is usually to facilitate ease of stock movement, as well for the brokerages to limit losses to their clients for trading options for solo stocks.
For options, you can buy AND sell options, and these will lead to different consequences.
Buying options (known as a call option) would give you, the buyer, a right but not an obligation to buy the underlying asset at a strike price before a certain date. This means you have to pay to buy this option from someone else in the market (don’t worry; the brokerage will pair you with a random party so you don’t need to actually find someone to buy from). This technique is usually used if an investor feels that the price of the asset will increase by that date, so the investor would buy it at a lowered price.
Selling options (known as a put option) would give you the right AND you are obligated to sell the underlying asset at a strike price before a certain date, should the buyer choose to exercise his right to buy the option. You’re usually PAID to sell an option to someone else in the market.
However, for this technique to work, you must have enough capital to sell an option at that price! If the other party were to buy the option you sold, it would mean that you would need to be able to own the 100 shares to be able to sell them to someone else.
Thus, to trade options, normally your account would need to have more than enough money for the price of that stock multiplied by a hundred, as well as a little more on top to pay for any commissions that the brokerage firm charges.
For example, each Intel stock (as of this writing) is worth USD$29.90. So, to buy or sell an option, you’ll need at least USD 2990, not including any commissions and miscellaneous fees the brokerage charges. So in effect, your account will need around USD 3100, just to be safe.
For example, you chance upon your dream house you really want to buy, but you don’t have the money for 5 months. So, you talk to the owner to negotiate a deal that gives you the option to buy the house in 5 months for $100,000.
The owner agrees, but for this option, you pay a price of $5000.
You bought the option for $5000 – you have the right, but not obligation to buy the house at $100,000.
The owner sold his option for $5000 – he’s paid $5000, but MUST SELL his house if you choose to buy it.
Now let’s consider 2 theoretical situations that can happen:
- The house actually was home to Elton John! Boom, the valuation of the house goes up to $2 million dollars. You can buy the house, and then sell it for a net profit of about $1.9 million.
- The house actually is falling apart, infested with rats, cockroaches and zombies. So, the valuation of the house is actually a lot less than $100,000 and your dream home now seems like a run-down place. So, you lose the $3000, but at least you don’t pay $100,000 for a crappy home.
Different Types Of Derivatives : Futures
Thankfully, futures are very similar to options, but the key difference is that people who purchase futures are obligated to buy the underlying stock from the seller, and vice versa, of that contract upon expiration, regardless of the price of the underlying asset. However, futures can be purchased on single stocks, which is highly useful for stocks that have extremely high valuation (i.e. Berkshire Hathaway A stocks).
For most of the brokerages, options are the most commonly used derivatives are options, followed by futures. To be honest, over the years of trading and investing, swaps and forwards in the commercial brokerage firms that cater to individual investors are hardly seen. This is probably due to their extreme complexity that makes them hard to understand.
Just know that if you want to learn how to make money in the markets today, it is vital for you to know how options work and how you can use this to your advantage!
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