| After the credit crisis of 2007/2008, a lot of | | | | ABC might not reach $11 by the future date. If it |
| attention focused on exotic "investment" tools | | | | does not reach $11, you would not exercise your |
| known as derivatives. Although exotic in nature, | | | | option (the derivative), meaning that you paid $1 for |
| derivative investments are really not that difficult to | | | | that option that you will not have had the |
| understand on the surface. Where it gets more | | | | opportunity to use. Of course, $1 is not much on its |
| complicated is in the details that financial institutions | | | | own, but multiply that by thousands and it becomes |
| arrange as "one-off" conditions. With regulation, | | | | more substantial. |
| however, transparency will improve and the | | | | How Do People Make Money With Derivatives? |
| derivative process should be as generic as what | | | | The people who make money with derivatives are |
| individual investors experience in their own derivative | | | | on the opposite end of the transaction of someone |
| trading. | | | | who loses money. In the example above, if you |
| What is a Derivative? | | | | bought an option to purchase ABC at $10 and you |
| A derivative is an intangible investment vehicle whose | | | | paid $1 for that option, the person who gets the $1 |
| value is determined by an another asset's value | | | | makes money. That person will also get to keep ABC |
| (therefore, a derivative's value is derived from | | | | stock if it does not reach $10. Therefore, if ABC is |
| another asset's value). If the price of the underlying | | | | priced at $5 when the derivative is sold and it only |
| asset increases by $1, the derivative value will change | | | | makes it to $9 by the strike date, then the person |
| accordingly. The most common type of "everyday" | | | | who sold the option makes $1 on the option sale and |
| derivative is the stock option. | | | | will have enjoyed an unrealized gain of $4 on the |
| How Are Derivatives Priced? | | | | underlying ABC security. |
| In the case of an stock option, the derivative is | | | | The most common uses for derivatives is to |
| priced based on a future, perceived value of the | | | | generate income (as in the case of the person who |
| stock. In the case of an option to buy stock ABC at | | | | sold the ABC option) and to hedge against potential |
| some future date, the expectation is that ABC will be | | | | losses (insurance). However, when large financial |
| priced higher than the derivative price plus the strike | | | | institutions invest billions of dollars into these types of |
| price (the price you agree to pay), allowing for a gain. | | | | instruments with the potential for 100% losses and |
| For example, if ABC is trading at $5 and you buy an | | | | no underlying asset (i.e. it is intangible) the prospect |
| option for $1, allowing you to purchase ABC at $10 at | | | | for mass failure is huge. For this reason, using |
| some future date, your expectation is that ABC will | | | | derivative products should only be considered by |
| be at $11 or higher by that future date. | | | | educated and high net worth investors, or |
| Why Are Derivatives So Risky? | | | | speculators who are comfortable with the complete, |
| In the example above, the risk lies in the fact that | | | | potential loss. |