Derivatives options are financial instruments that have value due to an underlying asset. In fact the financial security asset is called an underlier and it can be any of a number of financial instruments. For examples, derivatives might be stocks or bonds or commodities for examples. Sometimes the underlier is foreign currencies or indexes. The point is that the derivative has something that gives it value and makes it something investors want to own.

Most non-investors had never heard of derivatives until the recession. Suddenly the newspapers were full of stories of banks in trouble because they sold derivatives that had mortgage securities as underliers. When the housing market collapsed, the mortgage securities lost value which meant the derivatives were now worth less than their purchase prices.

Though the mortgage backed derivatives created a real nightmare for financial markets, the recession also gave a perfectly legitimate financial instrument an undeserved bad name. Even a retail investor can learn a lesson from the mistakes of the institutional investors. The lesson is: make sure you understand what you are buying before you buy it.

That may sound like an over simplification, but it’s not. Many of the global banks buying mortgage backed derivatives did not understand that the mortgages were overvalued. That is why investors are always advised to be familiar with the commodities or stock market where the underlier exists. This is not meant to be a lecture on derivative investing safety but rather an explanation of why investors should appreciate the versatility and profit making potential of derivatives.

Marketable and Versatile

Derivatives are marketable financial instruments. Derivative options are bought and sold in large quantities by private and institutional organizations. The main purpose is to hedge against risk of loss as prices of underlying assets change in the market place. But smaller investors are derivatives investing when buying stock options or options on futures contracts for example.

Derivative options first came into being in 1982. The options are agreements that give a buyer the right, but not the obligation, to buy or sell the underlying asset at a specific price and by a specific time. If the option expires, all you lose is the premium if you are the buyer. If you are the seller of derivatives options and the option is exercised, the risk of loss is higher because the underlying asset has lost value. If you have to buy the asset at a higher price and resell it to the buyer at a lower price, the loss can be quite large.

Pricing derivative premiums is complicated because so many variables go into the equation. For example, the premium amount is affected by the strike price and the amount of volatility. Measuring volatility is complex in and of itself and uses difficult mathematical formulas to calculate what are called The Greeks – delta, theta, gamma and vega.

To make pricing easier there are option pricing models such as the Black Scholes model.

If you are considering investing in derivatives options then the first step is learning all you can about trading derivatives. But when you are ready to do actual trading, you will need to work through a licensed and registered broker. The best way to insure you limit your losses is to only make trades you can understand and afford.

Oh if only the global banks had followed that advice two years ago there might not have been a recession!