The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance.
When one buys a cash instrument, for example 100 shares of ABC Inc., the payoff is linear (disregarding the impact of dividends). If we buy the shares at $50 and the price appreciates to $75, we have made $2500 on a mark-to-market basis. If we buy the shares at $50 and the price depreciates to $25, we have lost $2500 on a mark-to-market basis.
Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of $50, giving us the right but not the obligation to purchase ABC stock at $50 in 1 month's time. Instead of immediately paying $5000 and receiving the stock, we might pay $700 today for this right. If ABC goes to $75 in 1 month's time, we can exercise the option, buy the stock at the strike price and sell the stock in the open market, locking in a net profit of $1800.
If the ABC stock price goes to $25, we have only lost the premium of $700. If ABC trades as high as $100 after we have bought the option but before it expires, we can sell the option in the market for a price of $5300. The option in this case gives us a great deal of positional flexibility with a different risk/reward profile.
Article by Chand Sooran, Principal, Victory Risk Management Consulting Inc.
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