Derivatives & How They Work...Simplified

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.

Fractional Reserve Banking & Their "Bouncing" Baby Derivative...

A derivative is an agreement or contract that is not based on a real, or true, exchange, i.e.: There is nothing tangible like money, or a product, that is being exchanged. For example, a person goes to the grocery store, exchanges a currency (money) for a commodity (say, an apple). The exchange is complete, both parties have something tangible. If the purchaser had called the store and asked for the apple to be held for one hour while the purchaser drives to the store, and the seller agrees, then a derivative has been created. The agreement (derivative) is derived from a proposed exchange (trade money for apple in one hour, not now).

In financial terms, a derivative is a financial instrument - or more simply, an agreement between two people or two parties - that has a value determined by the price of something else (called the underlying).^[1] It is a financial contract with a value linked to the expected future price movements of the asset it is linked to - such as a share or a currency. There are many kinds of derivatives, with the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope of all derivatives possible is nearly endless. Thus, the real definition of a derivative is an agreement between two parties that is contingent on a future outcome of the underlying.

Source: Wikipedia (Derivative)