A derivative is...derived. It’s a something taken from something else. Like, a derivative of hot weather is thirst. A derivative of hunger is crankiness. Ya know…that diva thing. A derivative of a 132 QB rating in the NFL is serious wealth. And a derivative of a stock or bond or other security...is a something which derives its value based on the performance of that security.
There are basically two flavors of derivative—put options...i.e. the right to sell a security at a given price over a given time period...and call options, i.e. the right to buy a security at a given price over a given time period. The price of that option is derived from the price of the security.
Example time:
Colonel Electric, the downgraded new version of General Electric, is trading for 25 bucks a share. A derivative of its share price is sold in the form of a call option with a 30-dollar strike price, expiring about 90 days from now, on the third Friday of the end month.
Investors pay a price, albeit probably a small one, for the right to then pay 30 bucks a share for Colonel Electric at any time in the next 90-ish days until that option expires. That call option is thus a derivative of the Colonel Electric primary stock price.
Related or Semi-related Video
Finance: What Is a Put Option?83 Views
finance a la shmoop what is a put option? hot potato hot potato
ow ow! yeah remember that game well nobody wanted the potato, poor thing. the
players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]
of work the same way. a put option is the right or option or choice to sell a
stock or a bond at a given price to someone by a certain end date.
all right example time. you bought netflix stock at the IPO a zillion years
ago at $1 a share. that's you know splits adjusted. all right now it's a hundred
bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in
California that would be a tax of something like almost 40 bucks. well the
stock was a hundred but you keep only something like 60. feels totally unfair.
right so you really don't want to sell your stock but you're nervous about the [graph shown]
next few months that Netflix will crater for a while and go down ten
maybe twenty dollars. longer term though you think it'll hit 300. so this is the
perfect setup to maybe look at buying some put options on Netflix. if the stock
goes down your put options go up. with Netflix volatile but at a hundred bucks
a share ,you look up the price of an $80 strike price put option expiring in
December, and you know that's mid-september now .for five bucks a share
you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]
term life insurance. you pay the five dollars a share in the stock goes down
to 82 by mid December, worst of all worlds. well not only did you lose the $5
a share but your stock has lost $18 in value. but had Netflix really cratered
and gone to say $60 a share well you would have exercised your put and sold
your shares at 80 bucks. well those put options you paid $5 for
would be been worth 15 bucks a share. in buying that put option you've [equation shown]
guaranteed that your loss will be no more than a $75 value for your Netflix
position at least for that time period and ignoring taxes. well remember that
options expire after December whatever like the third Friday of the month it's
usually when options expire, you then have no protection and your shares float
along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]
raunchy. yeah well that's naked put options.
that's what they really are people.
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