Derivatives can be defined as any value which is based upon any other asset. In other words, it tends to derive its value from something else. Speaking with reference to stock derivatives, the term can be explained as a form of stock option which provides the buyer a right (not an obligation) to purchase 100 shares of a particular stock on a pre-set price. This is of the reason that the value of the option is dependent upon what the stock is reliant. For example, if a company’s stock option losses money makes money or is at breakeven point, it will depend greatly upon what the company does. As a matter of fact, the option will derive its value from the company’s stock.
Types of derivatives
Banks make use of derivatives so as to remain protected against interest rate changes. Also startup employees are offered stock options so they own this element as well. Many insurance contracts are also structured to have these through which they protect lenders if their loan conditions are not good. Energy producing companies also use futures so as to lock the prices of oil when they are about to highly protect the company. Moreover, even Airline companies make use of futures for locking oil prices when they are lower. For example, the southwest Airline used through which it paid $10 per barrel for a very long time even when the oil prices were $100+ per barrel. Additionally, there also exist weather derivatives through which most businesses are protected against hurricanes.
Derivatives are normally classified into the following two categories:
-Futures: It is a contract to either buy or sell quantities of a financial instrument or a commodity on a set delivery time in future as well as a pre-determined price.
-Options: It is a contract, not an obligation, through which the buyer has the right to buy or sell shares of the primary security at a pre-set price and before or on a specific time period.
Are equity options dangerous?
Although, incorporating derivatives tend to help the entire economy by reducing the level of risk for startup employees, oil companies, farmers and various other businesses however, they are also exposed to systematic risk. There are only few companies which are operating the major portion of derivatives that are being traded all over the world. This eventually means that if any one of those companies goes bankrupt, it will impose a daisy-chain impact which will cause other firms to fail as well thereby, swiping the entire financial network.
An example of this can be associated with the failure of Lehman brothers which was very popular in the period of credit crisis. If the Federal Reserve, FDIC, Treasury and various other government agencies would not have intervened, this daisy-chain effect would have been succeeded.
Although, derivatives might not be great financial tool that can be used by an average investor however, they have the ability to add in value to the society when they are used appropriately and with moderation. If their usefulness as well as their risks is understood clearly, they can turn out to be really helpful for investors to hedge risks.