Financial derivatives allow investors to benefit from the price movement of a security without owning it. Options and futures are the most common types, with underlying assets including stocks, bonds, commodities, and currencies. They offer exposure to expensive assets at a lower cost, with greater flexibility. Options give the right to buy or sell at a predetermined price, while futures require the purchase of the underlying asset at a set time and price. Derivatives can be based on anything with value that can fluctuate over time.
Financial derivatives are investment instruments that allow an investor to benefit from the price movement of a specific security without immediately gaining ownership of the security. In this way, an investor can become involved with a security at a lower cost than it would cost to purchase it outright. The two most common types of financial derivatives are options, which allow an investor the opportunity to buy or sell an underlying security, and futures, which force the contract holder to buy the underlying security. Derivatives also differ in terms of the types of securities, which can include stocks, bonds, commodities, and foreign currencies, that underlie the contracts.
To get involved with some of the companies that dominate the stock market, an investor often must put up a large amount of cash. However, such an investment can often take a long time to materialize, which means that the investor’s assets and liquidity may not be affected immediately. Financial derivatives provide opportunities for investors to gain exposure to such stocks and other expensive assets at a fraction of the price and with much greater flexibility. The contracts are called derivatives because they derive their value from the performance of these underlying assets.
Options are among the most popular financial derivatives, especially since many employers offer employer stock options. A basic stock option contract gives the owner the right to buy, with a call option, or sell, with a put option, 100 shares at a price known as the strike price. If the buyer of an option, who must pay a price to own the contract, can anticipate the movement of the share price, he can profit from the difference between the strike price and the final share price.
Futures are financial derivatives similar to options in that a party can buy some underlying asset at some point in the future at a predetermined price. However, they differ from options in that the buyer must purchase the underlying asset at the time and price stipulated in the contract. No premium is paid for the futures contract itself, which also makes it different from an options agreement.
It is important to note that shares are not the only underlying assets used in financial derivatives. Just about anything that has some sort of value that can go up or down over time can be used in a derivative contract. For example, commodities like gold or silver are often the basis of futures contracts. Foreign currencies, which can rise or fall in value compared to each other, are also popular assets used by investors in futures contracts.
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