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 Put Option?83 Views
finance a la shmoop what is a put option? hot potato hot potato
ow ow! yeah remember that game well nobody wanted the potato, poor thing. the
players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]
of work the same way. a put option is the right or option or choice to sell a
stock or a bond at a given price to someone by a certain end date.
all right example time. you bought netflix stock at the IPO a zillion years
ago at $1 a share. that's you know splits adjusted. all right now it's a hundred
bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in
California that would be a tax of something like almost 40 bucks. well the
stock was a hundred but you keep only something like 60. feels totally unfair.
right so you really don't want to sell your stock but you're nervous about the [graph shown]
next few months that Netflix will crater for a while and go down ten
maybe twenty dollars. longer term though you think it'll hit 300. so this is the
perfect setup to maybe look at buying some put options on Netflix. if the stock
goes down your put options go up. with Netflix volatile but at a hundred bucks
a share ,you look up the price of an $80 strike price put option expiring in
December, and you know that's mid-september now .for five bucks a share
you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]
term life insurance. you pay the five dollars a share in the stock goes down
to 82 by mid December, worst of all worlds. well not only did you lose the $5
a share but your stock has lost $18 in value. but had Netflix really cratered
and gone to say $60 a share well you would have exercised your put and sold
your shares at 80 bucks. well those put options you paid $5 for
would be been worth 15 bucks a share. in buying that put option you've [equation shown]
guaranteed that your loss will be no more than a $75 value for your Netflix
position at least for that time period and ignoring taxes. well remember that
options expire after December whatever like the third Friday of the month it's
usually when options expire, you then have no protection and your shares float
along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]
raunchy. yeah well that's naked put options.
that's what they really are people.
Up Next
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.
What is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...