A derivative is a financial contract whose value comes from an underlying asset or reference variable, such as a stock, commodity, currency, or security. It sets rules for a future transaction and can help manage risk or speculate on price movements. section 1.2.7 section 7.4.1
Common derivative arrangements include:
- Options give the buyer the right, but not the obligation, to buy or sell an asset at a strike price before expiration. A call targets a price increase; a put can protect against a price decline. section 1.2.7 section 7.4.1
- Futures lock in a pre-agreed price, allowing producers or other participants to reduce exposure to later market movements. section 7.4.1
- Swaps exchange assets or cash flows over time, such as currencies, to reduce borrowing costs and exchange-rate risk. section 7.4.1
Protecting a stock position with a put
Pedro owns ACME stock purchased at $100 per share and buys a put allowing him to sell at $95 after an approaching earnings call. If ACME stays above $95, the premium functions like insurance. If it falls below $95, the put limits his selling price to $95 and reduces the loss. section 7.4.1
An option premium can be understood like paying for an API key: it grants access to a buy() or sell() action under specified conditions. The buyer can let the key expire, limiting the loss to the premium. The seller receives that premium but assumes an obligation; writing a put can require buying the stock at the strike price even after a severe decline. section 1.2.7
