For many casual investors, the world of derivatives and stock options may seem somewhat complex. In many situations, these two terms are mistakenly used as synonyms, creating an additional layer of unnecessary complexity and frustration. Although neither derivatives nor stock options are essential for the majority of investors, taking the time to properly understand how these investment platforms are used may create new opportunities and open new doors to profit.
Generally speaking, stock options are a form of derivative that allow investors to buy or sell a particular stock for a specific price at a predetermined moment in the future. Ultimately, derivatives and stock options are far more alike than they are different.
Stock options are a form of derivative that is widely traded today. The term "derivative" encompasses a variety of investment tools, ranging from stock options to contracts for bonds, currencies, interest rates and a variety of other mediums.
Understanding The Basics of Derivatives
A derivative is essentially a contract initiated between two individuals – the writer of the contract and the buyer – that assigns terms under which the buyer can either purchase or sell an asset for a specific price at a point in the future. The price of the contract itself is determined by the continued fluctuations in price of the asset as a result of market volatility. A derivative contract can cover a broad range of assets, including conventional investment platforms such as stocks and bonds, as well as more unique assets such as interest rates and currencies.
When a derivative contract is initiated, it is often done so using a leveraged position. The use of borrowed money to fund these contracts allows buyers to create opportunities for a significant profit. That being said, leveraged positions also increase the amount of risk involved in the contract proportionally. In the event that the market does not respond as the contract buyer anticipated, significant losses could result.
The vast majority of derivatives are not traded on exchanges due to the nature of the assets involved. That being said, investors who are seeking to purchase derivative contracts involving exchange-based assets, such as futures contracts or stock options, can be purchased through exchanges.
Exploring Derivatives and Risk
As mentioned previously, the vast majority of derivatives contracts are not purchased through major exchanges. Instead, these contracts are bought and sold through what are known as the over-the-counter, or OTC markets. The OTC marketplace is significantly less regulated than major exchanges, which can be both beneficial and potentially hazardous to investors. Without the oversight included in the major indexes, investors have the option to explore a variety of non-standardized derivatives contracts if they so choose.
One of the biggest risks associated with the OTC markets is what is referred to as counterparty risk. Counterparty risk can be defined as the probability that the other member of a contract defaults on their fiscal obligations. Because these contracts typically involve a significant length of time between contract initiation and contract expiration, it is impossible to guarantee with full confidence that the counterparty to a derivatives contract in the OTC marketplace will be able to fulfill their financial obligations when settlement occurs.
Derivatives and Hedge Funds
Although derivatives do carry their fair share of risk, they are considered a valuable tool for hedge fund managers who are willing to do the necessary marketing research. This is due to the fact that these contracts can be used as a hedge to offset potential losses from other more traditional positions. Of course, this does not mean to imply that hedge funds are somehow immune to the type of counterparty risk mentioned previously, but rather, that the risk of counterparty default, particularly if a fund manager buys and sells exchange-traded options, is less than the potential security provided by a hedged market position.
Defining Stock Derivatives
A stock option is a specific type of derivative contract. The mechanics of a stock option can best be described as follows: the contract initiated between buyer and seller for stock options provides the buyer with the privilege of purchasing or selling an agreed-upon number of shares of a particular stock for a specific price at a pre-determined date in the future. Unlike a futures contract, stock options give the buyer of the contract the opportunity to purchase the shared in question but do not obligate them to do so.
Exploring the Mechanics of Stock Options
Stock options are traded through the Chicago Board Options Exchange rather than the OTC markets. Fundamentally, every stock options contract is defined as either a "put" or a "call." When an investor purchases a call, they are essentially buying the right to purchase the named stock asset at a given price within a specific period of time prior to the expiration of the contract itself. Inversely, when an investor purchases a put contract, they are buying the right to sell a designated quantity of the named stock asset for a designated price prior to contract expiration.
In the world of stock options, each options contract sold to a buyer is equivalent to 100 shares of the stock in question. So, for example, if an individual chooses to purchase 80 call options contracts of stock 'X,' this would cover 8,000 shares.
Stock Options and Strike Price
Once an option has been purchased, the buyer of the contract will be able to generate a profit on the contract if the value of the contract exceeds or falls below the strike price, depending upon the specific type of contract in question. When a stock option has reached a point where exercising the contract would result in a profit, it is said to be "in the money."
Once the option has been purchased, a specific expiration date will be assigned to the contract. For stock options, contracts will typically expire on the third Friday of the listed expiration month. If the owner of the contract does not exercise their rights prior to the expiration date, the contract itself is voided and these privileges are no longer granted.
Both "American" and "European" stock options are available for purchase, each of which has a different outlook on the rights of the contract buyer. In American options, the contract holder has a right to exercise their buying or selling privileges at any point prior to contract expiration. This differs significantly from European options, however, in which the contract holder is only allowed to redeem the option on the date of expiration. That being said, the bulk of investors do not need to worry about whether or not they are purchasing American or European options due to the fact that exchanged-based options contracts are exclusively American.
Stock Options and Price Premiums
Due to the inherent risk carried by the seller of the options contract, a price premium will be added to the sale price of the option. The size of the premium will typically depend on a variety of factors, ranging from current volatility in the marketplace to the length of time between contract initiation and expiration. The premium paid by the buyer of the options contract will not be able to retrieve this money once it has been paid.
As an example, if a stock options contract expires, the holder of the contract will not only lose the option to buy or sell the shares in question, but also the premium they paid to hold the contract throughout its lifespan.
Differences Between Derivatives and Stock Options
It is difficult to immediately pinpoint the differences between derivatives and stock options due primarily to the fact that a stock option is a form of derivative rather than an entirely separate market entity. As such, the core fundamentals of stock options are virtually identical to those of derivatives, namely the use of a contract between buyer and seller and the rights granted to buyers once a contract has been sold.
It is possible, however, to state that there are some differences between stock options and other derivatives that are currently being traded. With that in mind, it is critical that aspiring options or derivative traders take the time needed to thoroughly analyze the ins and outs of all available investment tools in order to ensure that they know specifically what they are trading and what they need to do to generate a profit.
Ryan Cockerham is a nationally recognized author specializing in all things business and finance. His work has served the business, nonprofit and political community. Ryan's work has been featured on PocketSense, Zacks Investment Research, SFGate Home Guides, Bloomberg, HuffPost and more.