A derivative is a financial product that gives you the option of fulfilling a buy or sell contract by some point in the future. Also called options, this product allows traders the option of buying or selling a stock at a previously agreed upon price. This can be a very powerful trading tool if used right. Because they present traders with the “option” of buying or selling, they can help minimize risk if you have a very clear idea of where a stock is headed price-wise.
An option does not create an obligation like a futures contract does. Because they present so much freedom to traders, they have a larger contract lot cost. For example, suppose that shares of XYZ are currently at $10.00. If you think that their price will rise in the future, you might want to enter a contract with a low price so that you can buy those shares at the lowest possible price. So you enter an option to buy the shares at $10.50 with the hopes that prices will increase drastically. If the expiration date is one year from the time of purchase, if the price goes above $10.50 all the way up to $11.00, you can fulfill your option contract at $10.50, then immediately sell your shares at the higher price. Understanding Forex News can also help you better understand derivatives.
In this above scenario, your profit would be the amount of shares optioned multiplied by $0.50 minus the contract fees. Obviously the farther away the expiration date, the more the contract will cost since there is more of a chance that the price will fluctuate above the profit level.
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