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What is a derivative?


A derivative is a security whose value depends solely on the value of another asset, such as a stock or commodity; it has no intrinsic worth in itself. Derivatives – futures contracts and stock options are two common types – are often the right or obligation to buy or sell something at or before some point in the future. Because a derivative is merely a piece of paper with a claim on shares of stock or quantities of gold or oil or copper or soybeans, and is not a tangible asset, it is often possible to obtain enormous leverage when trading derivatives.
A futures contract to buy or sell 100 ounces of gold, for instance, has a face value of roughly $160,000, but it can be traded by putting up as little as $11,475. If you buy a contract and the price of gold rises $115 an ounce, that’s about a 7 percent rise in the metal’s price but you’ll double your money if you sell the contract at that point. The problem is that the same hypersensitivity to price movements works in reverse, leading to the possibility of very large, sudden losses. In that case, the holder of the contract will be required to put up more money to maintain the position or else close it. That’s why investors who don’t know what they’re doing – which is most investors, and not just amateurs either – should steer well clear of derivatives speculation.
If you want to use derivatives to hedge a position you hold in your portfolio, it’s a different story. Say you own 100 shares of Apple and you’re worried that it may suffer a temporary setback after its strong run of recent years. You could sell a call option, giving someone the right to buy the stock from you at a certain price by a certain date, and collect a fat premium for doing so. In mid-December, with the stock at around $379 a share, an option to buy it at $380 by mid-July was trading for about $41 a share. If you sell the option, you’ll suffer no loss on the stock as long as it stays above $338. If Apple rises and you have to sell your shares at $380, your profit will be enriched by $41 a share, the amount you receive in the option sale. Not a bad deal either way.
-Conrad de Aenlle