A beginner's guide to derivatives

Derivatives are one of the fastest-growing segments of the financial market. If you want to know more about how they work, how to determine their prices and what the risks are, this brief guide is a good place to start.

This is the time of year when stock market volume picks up and the financial world becomes more active. Don't get left trailing in the market's wake, wondering how you're going to grab your next piece of the pie. Simply plug yourself into the fastest-growing segment of the investment market: derivatives.

Simply put, a derivative is an investment vehicle that derives its value from an underlying asset. Derivatives are available for many products in the investment world - all you need is an underlying market and you can construct derivatives from it. Specifically, they include commodities and interest rates. But the most commonly-used derivatives for regular investors are options.

Many investors end up confused because they don't know how derivatives work, and find the terminology tricky-sounding. Don't join them. These investments are powerful and profitable...

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

How to price derivatives: the Black-Scholes Model

Derivatives are actually easy to understand and use, thanks to two men: Fischer Black and Myron Scholes.

Together, these two developed the Black-Scholes Model back in 1973 - a mathematical model that allows investors to determine derivatives prices.

With regard to options, the Black-Scholes Model allows you to determine how much an option is worth by plugging numbers into a formula that asks for specific inputs common to all derivatives. Among these factors are:

The price of the underlying asset - i.e. the stock price

The amount of time until expiration

The strike price of the option

The volatility of the underlying asset (how much it moves up or down in a given period)

The risk-free rate of return. This is usually the interest rate paid by the government or a bank on guaranteed investments like Treasury notes.

Once these factors are entered into the model, it spits out a price that gives you the fair value of the derivative. Black and Scholes won the Noble Prize for developing this model, and it's still widely used today as the guide by which options are priced.

How to use derivatives

Since derivatives allow you to control the underlying asset - either with the right to buy or sell it - you're implying that you can fulfill the transaction in the event that you have to buy or sell the asset. That means that with trillions of dollars worth of assets changing hands in today's marketplace, traders can get into trouble if they don't know what they're doing.

In most cases, however, investors use derivatives as a trading vehicle to capture the profits from the movement of the underlying investment. Because of this, derivatives are often referred to as leveraged investment. And, whenever leverage is employed, the results can be magnified - both up and down.

If an investor decides not close the trade and instead keeps the derivative until expiration, there can be two outcomes:

If the underlying investment doesn't meet the parameters set for the derivative, then the option is worthless at expiration. For example: If you buy an option allowing you to purchase underlying shares at $25, but the shares close at $24. In this case, you'd let the option expire - you wouldn't exercise your right to buy a stock at $25 if you could buy it on the open market for $24.

Alternatively, you may actually be obliged to buy or sell the underlying security based on the position you've taken. For example: If you sold an option that obligated you to buy shares at $25, but by expiration, shares are trading at $23, then you are obligated to buy the shares at $25 and deliver them to whomever bought the option from you.

Why use derivatives?

There are numerous derivatives strategies, but the common thread is that they all allow you to either buy or sell an investment without actually taking possession of it, with the ultimate goal of allowing you to profit from a move in the underlying asset in a specified amount of time.

And because derivatives trade for a fraction of the price of the underlying asset, you have the opportunity to spend less money to control more of the asset - a powerful benefit.

By Karim Rahemtulla, Chairman, Mt. Vernon Research for the Smart Options Report, www.smartoptionsreport.com

Thinking of using derivatives? You may also like to read Cris Sholto Heaton's recent article on derivatives for a morein-depth look intohow they work.

Non-subscribers can sign up for our FREE 3-week trial which gives access to this and all other articles on the site.