To some ‘derivatives’ is a scary word (we would know). After studying this topic in uni (and actually pulling good grades) the word slowly became something we were obsessed over. We feel like derivatives has this stigma of being extremely difficult and risky. A tool you should not use unless you’ve had years of experience. Okay, part of that is entirely true however; you’ve just gotta shake that mentality because like anything, education is key! For those of you asking what a derivative is… allow us to explain.
What is a derivative?
A derivative is a financial product or security where the price is derived (or dependent) from an underlying asset. An underlying asset in this case may be bonds, currency commodities, shares, interest rates etc. So, if the price of the underlying asset changes, so does the derivative. Keep in mind a derivative itself is still a contract between you and another party.
Different Types of Derivatives
- Options are a contract that gives the holder of the option the right (but not the obligation) to buy or sell an underlying asset at a specified price on a specified date.
- Futures or Forwards Contracts are an agreement to either buy or sell the underlying asset at some future point in time for a specified price
- Swaps are an over-the-counter financial product that allows parties to enter into a contractual agreement by exchanging cash flows. The two main types are interest rate swaps and cross-currency swaps. Mainly, they help to manage the risk exposures present in interest rates and foreign exchange currency.They can be direct swaps or through a third-party which acts as an intermediary, typically a bank. The bank would take a spread (percentage) from the swap payments.
We’re going to talk Options today (and probably for the next few weeks). If you invest in the stock market, you’ve probably seen this pop up on your trading screen and may have thought about using an option. There are two main types of options you can use when it comes to investing. These are called Calls and Puts. A Call Option means you are buying an option (remember our definition) and a Put Option means you are selling an option. Allow us to explain a Long Call Option – Firstly, Long is just another word for buy (don’t ask us why).
Now, if you are buying a Call Option, this pretty much means you are expecting the stock to go up. Remember the general rule of investing, “buy low, sell high”.
When entering into an option contract, you will pay a premium for the option with a strike price (the amount you exercise your option at) and expiration date of your choosing. A Long Call Option will give you leverage on your position without having to give up too much capital.
For example, you see a stock you really like and it’s trading for $20 right now. The Call Option on this stock is trading for $5. So, you could either buy 100 shares for $2000 OR you could enter into an option contract and buy 100 for $500. The one thing you need to remember however, is that options do have an expiry date. So if the price decreases, the maximum you can lose is the $500 premium you have paid and your option expires worthless. This is the risk associated with long call options – your risk is limited to the premium you pay.
Overall, a long call option can be of benefit if you don’t have the required capital to buy a certain amount of share at the market price. You can obviously see the risk in buying an option, but with a little education and confidence, this is a great way to make some extra income.