What is an Option Derivative?

Jim B.

An option derivative is a financial instrument that gives the investor the right but not the obligation to buy or sell some underlying asset. This practice is usually used with stock options, which allow an investor to either buy, with call options, or sell, with put options, 100 shares of some underlying stock. If the stock moves in the price that the option-holder anticipates, he can cash in by exercising the option and buying the shares at the strike price determined at the outset of the contract. Another way to profit from an option derivative is by selling the contract itself and benefiting from its increased value.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

Many investors look to stocks as their investments of choice, but these ownership shares of companies can be costly and take a long time to produce profits. Another choice an investor can make is an option derivative. It's called a derivative because its value is derived from an underlying asset, even though a contract-holder might never gain physical ownership of the asset. Options can be profitable investment opportunities to those investors with the ability to accurately speculate on stock price movement.

There is some basic terminology involved with an option derivative that an investor must understand. The premium is the amount paid by the buyer to the seller, and it is usually just a small percentage of the actual price of the 100 shares of stock underlying the option. An option seller sets the strike price, which is a set price that, once reached, allows the buyer to exercise the option to either buy, for a call option, or sell, for a put option, the shares. Finally, each option contract has an expiration date, which, when reached, renders the contract worthless.

For example, imagine that an investor buys a call option derivative for a stock with a strike price of $20 US Dollars (USD) per share. The price of the stock goes up to $40 USD per share before the expiration date. By exercising the contract at the $20 USD strike price, the investor is paying $2000 USD for the 100 shares, even though those shares currently have a value of $4000 USD.

The investor at that point could sell the shares and collect the profit, or he could hold on to them and hope they further increase in value. On the other hand, he might not want to take on the cost involved with buying the shares. Instead, he can just wait for the option derivative contract itself to go up in value, which it will as the underlying stock price rises. He can then sell the contract and profit from the increased premium he will be able to demand from a buyer.

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