Definition of a Stock Derivative

A stock derivative is a negotiable security (usually in the form of a contract) that derives its value from that of a specific stock, which is referred to as the underlying security. Some derivatives gain value if the stock drops in price ("puts") and are useful as a way of reducing risk (hedging) when investing in the stock itself. Others appreciate if the stock gains in value ("calls"). There are many types of stock derivatives, but the two most common are options and futures.

Leverage

The big advantage of stock derivatives is that they can gain as much in value as the stock changes in price but require a much smaller investment.

Options

A stock option gives you the right (but no obligation) to purchase (or sell) shares of the stock at a specific "strike price" until the option expires.

Futures

With a stock futures contract you agree (and are obligated to) buy or sell the stock at thee current market price but at some future date.

Calls

If from the time you buy the option or futures contract the stock rises, you can buy it at the lower price and then sell at the new higher price.

Puts

With a put, if the stock falls, you buy the stock and complete the transaction by selling it at the old higher price.

Risk

Derivatives magnify the profits you can make with a given amount of money. However, your potential losses are magnified to the same degree.