Investing in shares of a company’s stock can be quite complicated. In particular, one of most confusing aspects of stock exchange for beginning investors to grasp is the concept of derivatives, as few financial experts stop to provide an understandable description of how derivatives function.
A derivative is a type of security whose value is based upon the value of another stock or asset. When an individual or a company wishes to protect its investments, it may choose to purchase a derivative. Derivatives may be paid for by individuals who have made, or wish to make, a large financial investment in a company. More commonly, a derivative will be purchased by a small business, and in some cases, a large corporation.
In most cases, when an individual or a business purchases a derivative, they are gaining the issuing company’s permission to purchase 100 shares of stock for a specified price by a designated day. Therefore, if the value of stocks begins to fluctuate, the derivative holder will be permitted to purchase a large quantity of shares for the agreed upon price. This may benefit an investor if stock values increase. However, if stock prices decrease, derivatives may cause an investor to lose financial resources.
Such is the case with futures contracts. If stock prices have decreased when the contract expires, an investor will still be required to purchase the shares for the strike price. If this agreed-upon price is more than the current price of the shares, the investor will lose money.
An individual or a corporation may choose to purchase exchange traded derivatives, or over the counter derivatives. There are various differences between these two types of derivatives. It is common for investors to seek derivatives from organized exchanges, and for businesses to purchase derivatives over the counter.