What is a Derivative?

If you are brand new to stock trading and have only just started skimming through the headlines of financial news sources, or even if you are a seasoned investor who has been investing your own money for most of your life, there is a concept that has been appearing with greater frequency in the news over the past several years due to the 2008 financial crisis and most recently due to the European debt crises of Greece and Italy. The concept I am of course talking about are derivatives and they are perceived to be so profound and complex that people shudder at the mere mention of the term. It is no doubt that derivatives are complex in practice but they are not as difficult to understand as many people believe them to be and shouldn’t scare you away from learning everything you can about them because that will help you become greater at stock trading.

At its most basic level a derivative is simply a contract between two parties just like other financial instruments including stocks, bonds, leases, and loans, but what makes derivatives stand out from the other instruments is that it is a contract which is executed due to some condition, like an event by a certain date or a change in price, that happens to some other underlying financial instrument or asset and the contract would trigger an action between the two parties, most likely a payment. If you have ever learned about the derivative in calculus then you will recall that it is simply a measure of change and is represented by a tangent line based off of an underlying function – or for those who haven’t read up on calculus, it is basically taking a formula you are given and simplifying it so you can draw a line on a graph telling you the trajectory of the formula on the graph at any given x-y (longitude-latitude) point on a graph representing the formula. As an example, if you wanted to apply the concept of the derivative to the geometric formula for finding the area of a circle (pi multiplied by the square of the radius of the circle), then the original formula compared to its derivative would look like this:

 

Plugging in numbers to the derivative of the area of a circle formula would simply show you how much change happens to the original formula as you progress through a series of inputs, and when you apply this concept to financial derivatives you can see the similarities. For example, if you acquire a derivative contract that allows you the option to purchase shares of stock at a certain price and soon after that the stock’s price increases above the derivative contract price, then the value of your derivative contract would increase by a greater proportion the further the price of the underlying stock increased allowing you the option to either sell the contract to someone so they can execute it, or allowing you the right to execute it yourself and immediately sell the shares at a profit. It is important to note that this simple example doesn’t include other important derivative valuation factors like “time value of money” and the cost of the contract in your final decision to execute it, two crucial aspects that you will need to learn more about before you start trading derivatives.

Although the concept of a derivative can apply to many financial situations there are a few common types that you are most likely to see when your learning takes you deeper into this type of financial instrument:

  • Options – This is the type of derivative I described in the previous example that allows you the right to either purchase company stock at a certain price or sell stock at a certain price and the option will often expire if not executed by a certain time.
  • Futures – These are often used when trading in commodity markets and due to the effects of supply and demand and the uncertainty of weather as well as other natural factors in these markets for basic goods purchasing a futures contract would allow you the ability to set a purchasing or selling price for a good long in advance. For example, the giant shipping logistics company Federal Express uses an incredible amount of fuel in their day to day business, and especially due to the recent variability of gas prices this company decided that it was better to lock-in prices with futures contracts so they can better budget than get caught off guard in the future if gas prices were to take a sudden and great movement to higher prices. Futures allow Federal Express to lock in a price for gas years before they actually use a single drop of it.
  • Swaps – There are several types of swaps but the most common is known as the “Interest Rate Swap” and is a contract based around two parties agreement to exchange interest rate cash flows between a variable rate and fixed rate or vice versa. This is based around the idea that interest rates change, and if you have a financial instrument whose interest payments are based on a fluctuating interest rate that in itself is based on larger economic indicators and you ultimately believe the payments will decrease because of circumstances outside of your control then you can decrease your risk by creating a contract with someone else who believes the opposite and who will pay you fixed rate payments in exchange for your variable rate payments.

There are many ways to trade in derivatives and even if there was some terminology you weren’t sure of in these examples the concept you need to walk away with is that a derivative contract is based on two parties entering into an agreement to perform an exchange of some sort when or if a condition is met by an underlying asset. Our ability to better manipulate, organize, and understand data than in the past will lead to the increased use of derivative contracts. Learning and understanding the more common derivative methods now will allow you to have a competitive advantage over other traders in the future who only then realize how important these instruments are and should be to their entire valuation of a company’s stock. Staying ahead of the curve is a very important part to being a great investor and learning about derivatives is a great step towards your perfect stock trading method.

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