Derivatives - Stock Trading Terms

Derivatives are financial instruments that derive their value from an underlying asset, such as a stock, bond, commodity, or currency. Derivatives are used to manage risk, speculate on price movements, or provide leverage for investment strategies.

There are four main types of derivatives used in stock trading: futures contracts, forward contracts, options contracts, and swaps.

Futures contracts are agreements to buy or sell an underlying asset at a predetermined price on a specific date in the future. For example, an investor might buy a futures contract for 1,000 shares of a company's stock at a price of $50 per share, with a delivery date in three months. If the price of the stock rises to $60 per share by the delivery date, the investor can sell the futures contract and make a profit of $10 per share.

Forward contracts are similar to futures contracts, but they are not traded on an exchange and are typically customized to the specific needs of the buyer and seller. For example, a company might enter into a forward contract to buy a certain amount of foreign currency at a specific exchange rate in order to hedge against fluctuations in the currency market.

Options contracts give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price on or before a specific date. For example, an investor might buy a call option for 100 shares of a company's stock at a strike price of $50 per share, with an expiration date in six months. If the price of the stock rise above $50 per share by the expiration date, the investor can exercise the option and buy the shares at the lower strike price, and then sell them for a profit.

Swaps are agreements between two parties to exchange cash flows based on an underlying asset. For example, two companies might enter into a swap agreement to exchange cash flows based on interest rates, with one company paying a fixed rate and the other paying a variable rate.

While derivatives can be useful tools for managing risk and enhancing investment returns, they also carry significant risks. Derivatives can be highly leveraged, which means that small changes in the underlying asset's price can lead to large losses. In addition, derivatives can be complex and difficult to understand, which can lead to unexpected losses if they are not used properly. Therefore, it is important for investors to have a thorough understanding of derivatives before using them in their investment portfolios.