Derivatives are the esoteric equivalent of the mystery religions of the financial world. Though many invest in them and talk about them few actually understand them and those that do are often hard to understand.

Derivatives can be confusing but they are not near as complicated as one might think. For starters, let’s look at the a common definition of the word “derivative”:

derivative
1 : arising out of or dependent on the existence of something else.
2 : of, relating to, or being a derivative <a derivative transaction> -de·riv·a·tive·ly adverb
3 : formed by derivation
4 : made up of or marked by derived elements

There does that help? Not really. The reason it doesn’t help is because a derivative is really nothing in and of itself. So to say something is a derivative is really to say nothing at all unless you define what the derivative is deriving itself from (which still sounds confusing I agree).

Let’s look at one more definition before we get into defining a derivative for ourselves.

de·riv·a·tive
: a contract or security that derives its value from that of an underlying asset (as another security) or from the value of a rate (as of interest or currency exchange) or index of asset value (as a stock index)

NOTE: Derivatives often take the form of customized contracts transacted outside of security exchanges, while other contracts, such as standard index options and futures, are openly traded on such exchanges. Derivatives often involve a forward contract.

Okay now this helps us a bit more than the previous definition. Now we know that a derivative is a “contract” of sorts. So perhaps we can consider a derivative as being a security in the form of a written agreement setting out a specific value based upon something else. This seems to me the most clear explanation of a derivative. Thus, we know we have to know three things to understand a derivative:

• We must know the agreement or contract and what it specifies. This is the WHAT component.
• We must know the underlying “something else” which defines the value. This is the HOW component of a derivative (it tells you HOW to calculate the price).
• We must know how long this agreement is valid for (since by definition all contracts end eventually. If they didn’t we wouldn’t need a contract in the first place!) This is the WHEN component of a derivative.

So now that we better understand the definition of a derivative in it’s most pure form let’s examine a specific example. (As a side note consider the fact that as anything evolves it moves to higher and higher levels of abstraction. Knowing this, you could say derivatives were a perfectly predictable outcome of the evolution of investments.)

Okay, back to the example. Here is probably the most common derivative that a great majority of investors dabble in at one point or another – the stock option:

CALL – ABC Corporation MAY 25 100– 4.00

Okay this is close to the format you will find an option listed under though there are some variations. Most importantly we have the basic 3 components we need to understand a derivative.

WHAT – This does require some background information. Namely, the fact that options are based on 100 share lots. Knowing that this is the WHAT information we need – This is a CALL (option to BUY) for 100 shares at a price of 4.00.

HOW – The stock is based on ABC corporation and it gives one the right to buy at 100. Thus we know HOW to calculate the value of the option. For example, if ABC is trading at 105 then we know that this option (which costs $4000) will allow us to buy 100 shares at a price of $100 (equals $10,000) which means that the net cost for the stock would be $14,000 dollars. (This is called “in the money”.)

WHEN – We can see this agreement is valid until the market closes on May 25th of the given year.

So now we know how to value the derivative. In this case the contract is a derivative of the value of the current purchase price of 100 shares of ABC corporation.

Hopefully that gives you a very basic understanding of what a derivative is and how they are valued. If you can understand these basic principles you can apply them to the other types of derivatives regardless of how complicated they may sound.

Needless to say, it is easy to see how derivatives can grow more complicated. Since a derivative only needs to be based on something with a definable value then this opens the door for derivatives based on derivatives based on derivates ad infinitum. We explore some of these more complex types of derivatives in another lesson.

Information is for educational  purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Consult your financial advisor.