A Guide to Derivatives

Derivatives, which are contracts derived from an underlying asset's value, can add an extra dimension to your investing, providing you with more tools to manage risk and potentially profit from market volatility. Rather than trading the asset itself, when you buy or sell a derivative you agree to exchange money or securities at a future date, based on the underlying asset.

A stock option gives you the right to buy or sell stock at a certain price up to a given future date. The value of the right is directly related to the price of the underlying stock. If the market price of a share goes up, the right to buy it at a fixed price becomes more valuable. Conversely, if the market price drops, the right to buy the share at a fixed price becomes less valuable.

When you buy a call option, you have the right but not the obligation to buy the underlying security at the strike price for a specified time. A put option gives you the right to sell the security at the strike price. The premium is the price you pay for the option.

When the strike price of a call option is above the current stock price, the call is "out of the money." And when the strike price is below the stock price the option is "in the money." Put options are the exact opposite.

All stock options have an expiration date, up to nine months from the date the options are first listed. There are longer-term options called LEAPS available on many stocks. LEAPS have expiration dates up to three years from the listing date.

Other forms of derivatives include forward and futures contracts. With these contracts you can profit on expected future price movements in the underlying commodity, security, currency or interest rate.

How can derivatives be used in a portfolio?
You can use derivatives to hedge a position you want to maintain as part of your long-term portfolio. If you expect an adverse price movement in a stock, you could use derivative contracts (puts or calls) to go either long or short, taking an opposite position to the position you hold in the underlying stock. Since the value of the puts and calls generally parallels the value of the stock, you might be able to offset your expected loss.

You can either exercise an option and buy or sell the underlying security, trade the option to make a profit or hold the option as a hedge against a loss. If you think a stock's price is going to rise but aren't sure whether to buy the stock yet, you could buy a call option near the current market price.

If the stock price goes up before your option expires, you can exercise the option to buy the stock at the strike price. Then you could hold the stock or sell it at a gain and keep the profit, less the cost of your option. You could do the same thing with a put option if you think the stock price is going to fall.

If you expect a significant movement in the stock price, such as when quarterly earnings are released, but you're not sure which way the price will move, you could use a straddle. In a straddle you purchase or sell both a call option and a put option on the same stock. Depending on which way the price goes, one of the options will work to your advantage.

When you trade in derivatives as speculation, your goal is profit. With the leverage you gain with derivatives, you get market exposure that could be worth up to 10 times the money you deposit on margin. If prices go as you expect, this gives you the chance to earn gains much higher than you could achieve with just your investment in the underlying asset.

What are the risks of derivatives?
If you buy an option, you won't lose more than the premium you paid for the contract, even if the underlying security declines in value. This limits your potential loss while keeping the upside open-ended. Selling an option, however, entails much greater risk. For call options, you must pay the strike price of the securities, even if the securities themselves have lost value. This could be a significant difference, and don't forget the premium you paid for the contract. The same is true for put options, where you may find yourself paying a very high price for securities that have lost value.

The value of derivative contracts also declines over time if there is no significant movement in the price of the underlying securities. For example, if you're counting on volatility in a certain stock to drive market interest in your put options and the stock price stays stable, other investors won't be interested in buying your contract. The value of contracts also declines sharply as they near maturity, since there is less time for a significant price swing that would enhance the value of the option.

Are derivatives right for you?
Price fluctuations in derivatives can be amplified compared to changes in the underlying securities. You need to pay close attention to market movements and devote the necessary time to managing options. Time is generally on your side with long-term investments, but with derivatives, time can work against you.

When you sell options, you need to have the financial resources to cover a potentially significant loss along with the risk tolerance and time frame to absorb that loss. Derivatives are a poor choice for short-term investing or those nearing their investment time horizons. The added volatility could threaten any investment gains you've accumulated.

Derivatives should only be used by active investors (those who manage their own portfolios) with a thorough understanding of financial markets and the securities that underlie the derivative contracts. Some financial advisors suggest that individual investors avoid them completely, as even well-established banks and proven money managers have made derivate deals that lost significant amounts of money. Research thoroughly before considering investments in derivatives and enlist the aid of an experienced financial advisor who can guide you toward investments that fit your capital and risk tolerance.

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