A derivative is something that comes as an outgrowth of something else. There's a thing, and then another thing based on that first thing that can only exist because the first thing existed.
Take the 2017 Tom Cruise remake of the The Mummy. The movie was supposed to be the launch of Universal Studios' so-called "Dark Universe" franchise. There was going to be a series of movies in a classic monster "extended universe"...the Invisible Man, Dr. Jekyll/Mr. Hyde, etc.
The Mummy flopped. The Dark Universe died for good (probably). But why did the movie exist at all? Well, it was a double derivative.
The Mummy was a remake of the 1930s movies that made a lot of money for Universal back when train travel was the preferred way to get from California to Florida. It also rebooted the 1990s/early 2000s version of the franchise, also a money maker in its time. And the new Mummy movie was an attempt to recreate the success Marvel had with its Avengers-centered cinematic universe. See? Derivative...
So, on to equity derivatives. These are contracts whose value is based on some underlying equity, like shares in a public company. The category includes things like options and futures contracts.
For instance, shares of FullBodyWrap Corp. are trading at $10 and you think they are ready to jump. But you don't want to buy the stock outright. So, instead, you purchase an option to buy 1,000 shares at $12 a share, which expires a month from now. The option gives you the right (but not the obligation) to buy the stock. If shares of FBW rise above $12, you can exercise the option, flip the stock, and book the profit. if it doesn't, the option just expires.
You can also trade the option itself. Someone else might want to buy that right to purchase FBW shares. The price people would be willing to pay are based on where FBW is trading. An option at $12 is pretty cheap if the stock is stuck at $10. But, if the stock rises to $15 a share, the price for that option is going to jump significantly. The value of the option is based on the value of the underlying equity. That's an equity derivative.
Related or Semi-related Video
Finance: What Is a Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
Up Next
What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...
A derivative of a security is a "something" which derives its value based on the performance of that security... either a put option or a call option.