What Are Derivatives?
A derivative is a financial contract whose value is derived from the performance of an underlying asset, index, or rate. Rather than buying or selling the asset itself, you trade a contract that references that asset. Derivatives are used across global markets for hedging risk, speculating on price movements, and gaining leveraged exposure to assets.
The underlying asset can be almost anything: stocks, bonds, commodities like oil or gold, currencies, interest rates, or even market indexes like the S&P 500. Understanding derivatives investing begins with recognizing that these instruments are tools, not inherently good or bad. Their risk depends entirely on how they are used.
"Derivatives are financial weapons of mass destruction when misused, but powerful risk management tools when properly understood." — Adapted from Warren Buffett
Types of Derivatives
Options
Options give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specific expiration date. Options are the most accessible derivative for individual investors and are traded on major exchanges. They come in two varieties: calls and puts.
Futures
Futures contracts obligate both the buyer and seller to complete a transaction at a set price on a future date. Unlike options, there is no choice involved once the contract is entered. Futures are widely used in commodities markets (oil, wheat, gold) and by institutional investors to hedge portfolio risk.
Forwards
Forward contracts work similarly to futures but are privately negotiated between two parties rather than traded on an exchange. Because they are customized and unregulated, forwards carry counterparty risk, meaning one party might fail to fulfill the contract. They are most common in currency and interest rate markets.
Swaps
Swaps are agreements to exchange cash flows or financial instruments between two parties. The most common type is an interest rate swap, where one party trades a fixed interest rate payment for a floating rate payment. Swaps are primarily used by corporations and institutional investors to manage interest rate or currency exposure.
How Options Work: Calls and Puts
For most individual investors, options are the entry point into derivatives trading. There are two fundamental types of options contracts:
Call Options
A call option gives the holder the right to buy an underlying asset at a specified price (the strike price) before the expiration date. Investors buy calls when they believe the price of the underlying asset will rise. If the stock price goes above the strike price, the call option becomes profitable.
For example, if you buy a call option on a stock with a strike price of $50 and the stock rises to $65, you can exercise your right to buy at $50 and immediately have a position worth $65 per share, minus the premium you paid for the option.
Put Options
A put option gives the holder the right to sell an underlying asset at a specified price before the expiration date. Investors buy puts when they expect the price to fall, or when they want to protect existing holdings against a decline. If the stock price drops below the strike price, the put option becomes profitable.
For instance, if you own shares of a stock currently trading at $100 and you are worried about a short-term decline, buying a put option with a $95 strike price acts like insurance. If the stock drops to $80, your put allows you to sell at $95, limiting your loss.
Essential Options Terminology
- Strike Price: The predetermined price at which the option holder can buy (call) or sell (put) the underlying asset. This is the most critical factor in determining an option's value.
- Premium: The price paid to purchase the option contract. This is the maximum amount the buyer can lose. The seller (writer) of the option receives the premium as income.
- Expiration Date: The last date on which the option can be exercised. After this date, the option becomes worthless if it has not been exercised. Options can expire weekly, monthly, or at longer intervals.
- In the Money (ITM): A call option is in the money when the stock price is above the strike price. A put option is in the money when the stock price is below the strike price. ITM options have intrinsic value.
- Out of the Money (OTM): A call option is out of the money when the stock price is below the strike price. A put option is OTM when the stock price is above the strike. OTM options have no intrinsic value and consist entirely of time value.
- At the Money (ATM): When the stock price is equal to (or very close to) the strike price. ATM options have the highest time value relative to their price.
- Intrinsic Value: The amount by which an option is in the money. A call with a $50 strike when the stock trades at $55 has $5 of intrinsic value.
- Time Value: The portion of an option's premium above its intrinsic value. Time value decreases as expiration approaches, a phenomenon known as time decay or theta.
Basic Options Strategies
Covered Call
A covered call involves owning 100 shares of a stock and selling a call option against those shares. The investor collects the premium from selling the call, which generates income. If the stock stays below the strike price, the option expires worthless and the investor keeps both the shares and the premium. If the stock rises above the strike, the shares may be called away, capping the upside.
Covered calls are considered a conservative strategy because the stock ownership provides a "cover" for the obligation. They are popular among investors seeking to generate additional income from existing holdings.
Protective Put
A protective put involves buying a put option on a stock you already own. This strategy acts as insurance against a price decline. The put limits your downside loss to the strike price minus the premium paid, while preserving unlimited upside potential.
For example, if you own shares at $100 and buy a $90 put for $3, your maximum loss is $13 per share ($10 decline to strike plus $3 premium), no matter how far the stock falls. This is an effective way to protect gains without selling your position.
Long Call and Long Put
The simplest options strategies involve buying calls or puts outright. A long call profits when the stock rises significantly above the strike price plus the premium paid. A long put profits when the stock falls well below the strike price minus the premium. In both cases, the maximum loss is limited to the premium paid.
Options vs Stocks: Key Differences
| Feature | Stocks | Options |
|---|---|---|
| Ownership | Own a piece of the company | Own a contract, not the asset |
| Expiration | No expiration | Expire on a set date |
| Capital Required | Full share price | Only the premium |
| Leverage | No built-in leverage | Control 100 shares per contract |
| Maximum Loss | Entire investment (if stock goes to $0) | Premium paid (for buyers) |
| Dividends | May receive dividends | No dividends received |
| Complexity | Straightforward | Requires understanding of multiple variables |
Risks of Options Trading
Options carry distinct risks that every investor should understand before trading:
- Total Loss of Premium: If the option expires out of the money, you lose 100% of your investment. Unlike stocks, which can recover over time, an expired option has zero value.
- Time Decay: Options lose value every day as they approach expiration. This theta decay accelerates in the final weeks, working against option buyers and in favor of sellers.
- Complexity: Options pricing depends on multiple factors including the underlying price, strike price, time to expiration, volatility, and interest rates. Misjudging any of these can lead to losses.
- Leverage Risk: While leverage amplifies gains, it equally amplifies losses. A small move in the wrong direction can wipe out your entire premium quickly.
- Liquidity Risk: Not all options are actively traded. Illiquid options may have wide bid-ask spreads, making it expensive to enter and exit positions.
- Unlimited Risk for Sellers: Selling naked calls (without owning the underlying stock) carries theoretically unlimited risk if the stock price rises sharply. This strategy is not suitable for most investors.
Who Should Consider Options Trading?
Options are not suitable for every investor. Consider options trading if you meet the following criteria:
- You have a solid understanding of stock investing fundamentals
- You can afford to lose the entire premium without affecting your financial goals
- You have the time and willingness to monitor positions and market conditions
- You understand the mechanics of leverage, time decay, and implied volatility
- You have a specific strategy in mind rather than simply speculating on direction
Beginners should start with paper trading (simulated trades) to practice options strategies without risking real money. Most brokerages offer paper trading tools specifically for options. When you do begin trading with real capital, start with defined-risk strategies like covered calls and protective puts before exploring more advanced approaches.
Getting Started with Options
- Build your foundation: Ensure you understand stock investing before adding options to your toolkit
- Get approved: Apply for options trading approval with your broker, which requires answering questions about your experience and financial situation
- Learn the Greeks: Delta, gamma, theta, and vega measure how option prices change in response to various factors
- Start with covered calls: If you own stocks, selling covered calls is one of the safest ways to begin
- Paper trade first: Practice strategies with virtual money before committing real capital
- Define your risk: Never risk more than a small percentage of your portfolio on any single options trade
