Derivative

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.