Stock derivatives are contracts that allow an investor the opportunity to buy shares of an underlying stock at some point in the future. The two main types of derivatives are options, which give the contract holder the option but not the obligation to buy shares at some point in the future, and futures, which stipulate that the buyer must buy shares at some point in the future at the current market price of the stock. An investor in stock derivatives is essentially speculating on the price of stocks without actually purchasing the actual shares. Derivatives allow investors to make short-term profits while investing relatively small amounts of capital.
When someone buys shares of a particular stock on the stock market, he is actually purchasing a piece of ownership in the company issuing the stock. Stock investments can be relatively pricey, and it may take a long period of time to see any return on the investments. As a result, many investors may get involved with the stock derivatives market, which allow them to essentially bet on the price movements of stock without actually purchasing them.
There are many advantages to trading stock derivatives. For one, the price of a derivatives contract is usually just a fraction of the cost of the underlying stock, allowing for investors with more modest budgets to become involved with the biggest stocks. In addition, the contracts themselves may be bought and sold. This allows investors to get in and out of contracts with great flexibility, offering them more opportunities to spread out their investment capital.
One of the two major types of stock derivatives are stock futures. A futures contract stipulates that one investor buys 100 shares of some underlying stock from a seller at the current price of that stock at some predetermined date in the future. If the stock price goes up by the time that date arrives, the buyer will make a tidy profit, either from the appreciated value of the shares or from selling the original contract at a premium. By contrast, the seller would benefit if the price goes down.
The other main way to trade stock derivatives is through stock options. When an investor buys a stock option, he purchase the right to either buy, with call options, or sell, with put options, 100 shares of an underlying stock. An option may be exercised once the stock price reaches a predetermined strike price, which is set below the current price for put options and above it for call options. With options, investors attempt to judge the way that a stock will move and the timing of when it will make that move.