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.
Related or Semi-related Video
Finance: What are stock options in 90 se...0 Views
Finance allah shmoop what are stock options in ninety seconds
or less Here's a stock ibm not the tech company
This one makes an anti constipation drug It's trading at
one hundred eighty bucks a share Okay so here's an
option of buy a share of ibm anytime in roughly
the next three months For one hundred ninety dollars a
share it's called a call option If you really believe
the ibm will go to say two hundred dollars a
share in the next three months well you'd be what's
called ten dollars in the money then or then have
a stock option or call option with a strike price
of one hundred ninety dollars which would then have intrinsic
value of ten bucks a share On the other end
of the buy sell desk is the gal willing to
sell you that call option for three bucks Three bucks
a premium So gut check time Would you pay three
dollars for the right to buy a share if ibm
for ten dollars higher than where the stock's trading now
today Meaning that to break even in the next three
months the stock has to trade all the way up
from one hundred eighty dollars a share to one hundred
ninety three dollars a share jobs for you to get
your money back but it goes to two hundred two
share Well if you sell that option you'll have invested
three bucks a share for a net return of seven
bucks in just three months or less And yes we're
ignoring commissions and taxes here because well in problems like
this or just a in the book but three dollars
into seven only three months Yeah that's a great score
You'd have more than doubled your money And on an
annualized return basis that's over a nine hundred percent dish
return really good score but with a much more likely
case that you spend three bucks to buy the option
and it expires totally worthless And then you've lost your
entire investment in that option So that's a call option
It's evil twin is a put option So whereas a
call options the rightto by a security to set price
by a certain set date a put option is the
right to sell that option We'd go into more detail
here but we're promised ninety seconds
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