General Definition
A derivative is any contract that concerns the buying and selling of securities or commodities at a future date. For example: you’re a restaurant owner and you meet a great apple supplier. You currently have plenty of apples but you know you will need them in the future. So you agree to buy 1000 apples from the supplier in one month at a particular price.
Futures Contract
The above example is a derivative called a futures contact. The buyer and the seller have an obligation to satisfy that deal in a month; no matter what the market price is at that time.
Option
The other main type of derivative is called an option. Unlike a futures contract, an option doesn’t have to be satisfied. The holder of the option has the choice or the option to cancel. For example: the restaurant owner tells the apple supplier they will pay the supplier 1 dollar per apple in a month. If the supplier agrees, then even if the market price rises to 100 dollars per apple, the restaurant owner can still buy apples at 1 dollar a piece. If the market price drops to 20 cents apiece, the restaurant owner can cancel the contract and buy it at the lower market price. The reason the supplier is willing to offer that option is that the restaurant owner pays the supplier a premium as a way to compensate the supplier for the market price risk. So the restaurant owner might buy the option contract from the supplier for 50 dollars. There are two types of options; calls and puts.
Calls
When you buy a call, you are buying the right to buy a stock at a certain price no matter how much the market price rises. The above example is a call option; the restaurant owner with a call option can buy an apple for a dollar no matter what the market price.
Puts
When you buy a put, you buying the right to sell a stock at a certain price no matter how much the market price drops. For example: Imagine that restaurant owner is really desperate to buy those apples in two months but the supplier doesn’t want to sell to him. The restaurant owner tells the supplier that he’ll pay in two months the market price or the price specified in the option (strike price); he’ll pay whatever price is higher. The supplier takes the deal because now, even if the market price goes down (a common risk in sales), the supplier can always sell their apples at a high price.
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Questions for the comments
Did my explanation make sense? Do you agree or disagree with what I said?
