- With regard to the financial markets, a derivative is a financial instrument that is based on an "underlying" asset. This instrument "derives" its value from the asset that possesses true material value. The value of a derivative is based on its holder's right to exercise specific functions on the underlying asset. Although they are traded speculatively, they are typically used as hedging instruments against different types of market risks. It is important to understand that the derivative itself is not considered a tangible asset; rather, its value lies in the rights it provides the holder. When referring to stock derivatives, these pertain to derivatives on which the underlying assets are shares of stocks or stock market index funds.
- The most common type of stock derivative is the stock option. Quite simply, a stock option gives its holder the right to buy or sell 100 shares of a given stock at a predetermined price for a predetermined period of time. As a hedging instrument, the stock option provides several alternatives to investors. There are two types of stock options available. The first is a Call option, which gives its holder the right to buy 100 shares of a particular stock at a predetermined price within a predetermined time period. The second is a Put option, which gives its holder the right to sell 100 shares of a stock at a predetermined price within a predetermined time period.
As an example of hedging, suppose a trader owns 1,000 shares of stock ABC and wants to protect this position against an adverse market move. He can choose to buy 10 Put options, which gives him the right to sell those 1,000 shares at a predetermined price of his choosing that would thus protect his investment if the stock price were to drop within a certain time period. - Another type of stock derivative are stock index futures contracts. Futures are treated somewhat like options in that they have an expiration date, but they are bought at market price. For many years, the futures market has been a source of hedging against market risk for big corporations and banks. The most sophisticated stock traders also use futures as a safety hedge as well. For example, suppose an investor is bullish and is holding large positions reflecting her view of the stock market. She can hedge against an adverse market move by selling the Standard and Poor's (S&P) 500 Index Futures short, which would increase in value if the stock market were to fall. The S&P 500 Index is a set of 500 large companies trading in the stock markets that are selected to represent the overall health of the market. By following this index, traders can gauge how the markets are doing overall.
- Possibly the most widely used type of derivative among large companies are swaps. These are contracts in which two or more companies agree to exchange assets on a specified future date. These swap derivatives could be based on any number or combination of underlying assets, such as bonds, loans, stocks, commodities or even real estate. It is quite common for financial institutions to swap different types of loans, such as trading a variable rate loan for a fixed rate loan. The most unique element of swaps is that they are over-the-counter derivatives that are exchanged privately and not through a public exchange.
- While some of the most exotic trades in the stock market are comprised of stock derivatives, before attempting to use them, consider the following cautions. The derivatives markets contain some of the most savvy traders out there, so competition is fierce. Second, derivatives can be complex and traders must understand the techniques used to trade them. Finally, most of these instruments have very high leverage and one small market move could wipe out the entire account of someone without experience.
previous post
next post