Derivatives are a class of securities whose price is derived from one or more underlying assets but may include additional factors such as interest rates, time to expiration and various other economic factors. The derivative itself is a contract between two or more parties to exchange a fixed amount of the underlying security at a given date and price. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized as risky investments because of their high leverage.
This page will primarily focus on the two most common forms of derivatives: options and futures. The primary difference between options and futures is that options allow the right to buy or sell the underlying asset at expiration, whereas futures have an obligation to buy or sell the underlying asset at expiration.
Options
Options are a contract between two people for the right to exchange a fixed amount of shares (typically 100 shares per contract) of a given security at a given strike price on a given date. Stock options are issued as puts (downside exposure) or calls (upside exposure) and can be combined to create spreads, which are used for effective risk management.
Common options spreads:
Futures are a financial contract obligating the buyer/seller to purchase/sell an asset--such as a physical commodity or a financial instrument--at a predetermined future date and price. A futures contract will include the type and quantity of the underlying asset in a standardized format that is traded on a futures exchange. Some futures contracts require physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, an oil producer can use futures to lock in a given price to sell his oil at and reduce risk (hedge). However, individuals and hedge funds are allowed to speculate on the direction of oil by purchasing or selling oil futures.
This page will gradually expand to include ways to dynamically hedge your derivatives positions and explain various ways of pricing options and futures premiums.
This page will primarily focus on the two most common forms of derivatives: options and futures. The primary difference between options and futures is that options allow the right to buy or sell the underlying asset at expiration, whereas futures have an obligation to buy or sell the underlying asset at expiration.
Options
Options are a contract between two people for the right to exchange a fixed amount of shares (typically 100 shares per contract) of a given security at a given strike price on a given date. Stock options are issued as puts (downside exposure) or calls (upside exposure) and can be combined to create spreads, which are used for effective risk management.
Common options spreads:
- Vertical Spread
- Covered Call
- Collars
- Diagonal Spreads
- Backspreads
- Iron Condors
- Straddles and Strangles
- Butterflies and Condors
- Calendar Spreads
Futures are a financial contract obligating the buyer/seller to purchase/sell an asset--such as a physical commodity or a financial instrument--at a predetermined future date and price. A futures contract will include the type and quantity of the underlying asset in a standardized format that is traded on a futures exchange. Some futures contracts require physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.
Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, an oil producer can use futures to lock in a given price to sell his oil at and reduce risk (hedge). However, individuals and hedge funds are allowed to speculate on the direction of oil by purchasing or selling oil futures.
This page will gradually expand to include ways to dynamically hedge your derivatives positions and explain various ways of pricing options and futures premiums.
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