Understanding Derivatives and Futures

Here's where it gets tricky. Traditional, straight-forward stock market investing is simply buying shares of a company, in hopes of gaining a profit through dividends or increased value. Derivatives, however, are another type of financial contract that is a little fuzzier. A derivative isn't an equity, but is rather derived from an equity such as a stock or bond. When you own shares, you own a piece of a company. Not so with derivatives.

Two common types of derivatives are options and futures. An options contract is something you buy that doesn't give you any hard underlying asset, as is the case when you buy shares of stock. An options contract instead merely gives you the right to buy or sell some asset before a specified date, usually at a pre-specified price. Potential profits are very great here, but potential losses can be tremendous. When buying shares of stock for example, it's rare that your shares will lose 100 percent of their value. An options contract, on the other hand, can do so. For example, an options contract to buy shares of stock at $10 at a future date becomes useless if the price of that stock drops to $9. On the other hand, the profit potential comes in when you have an options contract to buy shares of stock at $10 at a future date, but then the actual share price rises to $11. You get the stock at $10, and immediately sell it at $11 and reap a big profit.

A futures contract differs slightly from an options contract, in that it is a binding agreement to buy or sell an asset. With a futures contract, you have the obligation to carry out the transaction; an options contract merely gives you the right to do so if it is advantageous. The advantage in these types of derivatives is that if the stock goes opposite from what you believe, you have only lost the price of the contract, which is usually substantially less than what you would have lost had you purchased the stock directly and suffered the subsequent loss in value. However, they are a lot more speculative, since you not only have to predict whether the underlying stock or asset will go up or down, you also must accurately predict how soon it will do so. If you're holding a stock directly, and the price goes down, you can choose to continue to hold it in the hopes that it will go back up. If however, you own an options contract, if the price of the stock goes down when you bet on it going up, you've lost all your money. There's no long-term element and no potential for recovery, as there is when you buy equities directly.

Dealing in derivatives such as options and futures is more complicated than buying and selling stock. You'll hear the phrases "call" and "put" bandied about. A call is a type of option that gives you the right to buy something at a predetermined price, by a specified date. You buy a call option when you believe the stock will rise in price by the expiration date. A put, on the other hand, gives you the right to sell an asset at a predetermined price by a specified date. You buy a put option if you believe the stock price will fall before the expiration date.

Investing in these types of derivatives requires a lot of careful study, and investing with money that you are able to lose.

Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.