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Introduction to Derivatives


Editors note: This is the first of a six-part series.

We hear so much about derivatives, but the general public and even many professional traders aren't quite sure what they are or how they impact our lives. Because leverage is almost always employed (only a fraction of the notional value is required for margin), the derivatives markets dwarf all other markets. The best estimate of the size of these markets is $150 trillion. By way of comparison the value of all U.S. equities listed on the NYSE is about $12 trillion. Because derivatives introduce a great deal of leverage into the financial system and the size of these markets is so great, regulators are very concerned about derivatives' implications to the financial system.

The capital markets raise money for companies by selling what are termed cash securities, things that are familiar to most people like stocks and bonds. These are things people can buy or invest in and hold as assets to realize a return (although sometimes that return might be negative). There are also other hard assets like commodities and even real estate. These assets are all part of what is termed the "cash markets." Currencies are a little different: they are loosely considered part of the cash markets, although not a hard asset (a currency is a vehicle of investment and saving that has value only relative to other currencies). Derivatives by their nature are based on cash markets.

The definition of derivative is "something obtained from a certain source." A derivative then is a contract or agreement (this agreement almost always has a payoff and a time limit) whose value is based on the performance of a cash instrument (or more specifically its price movement). So a derivative contract basically says that if X happens to the price of the cash instrument over some specific period of time, one party will pay the other party Y. Common to all derivative contracts is an expiration date and leverage: In entering into the agreement, the parties are only required to post a fraction of the value of the eventual payoff.

In describing derivatives, I have broken the market into three basic product groups and written a primer on each:

1) Options
2) Futures
3) Structures (cash instruments with imbedded options)

There has been a great deal of academic discussion about the impact derivatives have made to the financial markets. In trading these markets over the years, there are two things I am certain of: Derivatives when used properly afford tremendous financial flexibility and because of the leverage they introduce, have caused a tremendous increase in overall volatility.

Click here to check out Part II: Getting Graphic With Options

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.
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No positions in stocks mentioned.

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