What is a Derivative?
In the world of financial markets, a derivative is a contract which derives its value from an underlying security or asset. I know that is an ugly sentence and that is the way Wall Street likes to say things so you remember only they can do what they do – which is false.
Put differently – a derivative contract (a derivative) is an agreement between two parties to make a decision or take an action in the future based in some set of terms and conditions – that’s it.
The vast majority of derivatives can be bucketed into four categories:
Derivatives have been coined by many as “Financial Weapons of Mass Destruction” however, when they are used properly and prudently, they can be very useful. Think of a scalpel, a scalpel is extremely sharp, if a scalpel is used improperly it can cause a great deal of harm however, in the hands of a surgeon who is using it properly and prudently, a scalpel can save your life.
This topic can be complex – but it doesn’t have to be – I will work on follow up material that goes deeper into the payoff structures and specific risks of the different types of derivatives but for today, let’s cover what these contracts are and what they actually do.
The buyer of an option has the right, but not the obligation, to buy or sell the underlying asset on or before a specified date (execution date) at a specific price (strike price.) Options come in two basic forms:
- Call Options (Calls)
- Put Options (Puts)
A call option gives the buyer of the call the right, but not the obligation, to buy the underlying. A put option gives the buy of the put the right, but not the obligation, to sell the underlying.
Options can be used to profit from increases, decreases or no change in the value of the underlying. There are a massive number of strategies that can be used to profit from virtually every price scenario. I will discuss the different scenarios in a follow up article.
There are four different ways to use an option
- Buy a call option
- Buy a put option
- Sell a call option
- Sell a put option
Selling an option is referred to as writing an option.
In contrast to options, futures obligate the long party (the buyer) to purchase the underlying on a specified date at a specified price – on the other side of the trade – the short party (the seller) is obligated to sell the underlying at a specified price on a specified date.
Imagine you and I were discussing the possibility of the Dow Jones Industrial Average (DJIA) hitting 21,000 by December 1st, 2017. I think is it a certainty, you don’t think there is any possible way, so you sell me a futures contract on the DJIA for 21,000 which executes on December 1st, 2017. Regardless of the value of the DJIA on December 1st, 2017 – I am buying the Index from you for 21,000.
One important characteristic here is that futures are traded on an exchange thus, they are regulated and standardized.
Unlike futures, forwards can be customized to cover any asset, any length of time, for any amount, etc… Forwards are traded “Over-The-Counter” or in private markets – directly between individuals as long as the two entities agree on the terms of the contract – they are free to execute the transaction.
I am convinced (hypothetically) there money to be made in kale (yes, the plant.) On the other hand, you view kale as a fad and you believe it will fall out of the millennial’s good graces in four years.
We decide to enter a forward contract to exchange 1,000 pounds of kale at $1.00 on March 1st, 2021 (the term is referred to as the tenor here is 4 years) – notice the value of the contract to either party at initiation is $0.00 because it uses today’s price. If you noticed an issue here – well done – the problem is we can’t store 1,000 pounds of kale in the pantry for four years and neither of us are kale farmers, at least I’m not, so how can we settle the contract?
Fast forward to the settlement date, March 1st 2021.
Kale has been experienced phenomenal growth and is currently selling at $3.00 a pound. Remembering that we aren’t kale farmers, we decide not to take physical delivery of the kale, instead, we will use cash settlement. The adversely affected party pays the benefitting party the difference in the cash value of the contract. Our contract called for 1,000 pounds of kale at $1.00 a pound for a notional value of $1,000. However, today, kale is selling at $3.00 a pound – 1,000 pounds at $3.00 gives a value of $3,000, given I’m the long party, you would cut me a check for $2,000 ($3,000-$1,000).
- Tenor – Length of the contract (4 years)
- Notional Value – Value of the underlying represented by the trade (1,000lbs. x $1.00 = $1,000)
- Physical Delivery – Delivering the notional amount of the underlying at settlement (1,000 pounds of kale)
- Cash Settlement – Exchanging the difference in contractual value at the settlement date (more popular for obvious reasons) ($2,000 = $3,000-$1,000)
Check back in next week for further discussion around Swap Contracts – which can get a bit tricky – and I don’t want to leave out any important details around the contracts.
If you have any questions / comments or general topics you would like me to discuss please let me know. Shoot me an e-mail at email@example.com
Thanks for reading!