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OPTION TRADING
Before we teach the Black-Scholes formula, we must first review the basics of stock option trading.
These include:
- derivatives
- call options
- put options
Derivatives
A derivative is a seemingly simple financial instrument.
| Derivative | A bilateral contract or payment-exchange agreement the value of which depends upon the value of some underlying asset, reference rate, or index. |
|---|
In other words, the value of a derivative is derived from something else.
In a derivative contract, the medium or rate of repayment is specified in detail. Likewise, the amount of repayment may be tied to some change in the underlying asset, rate, or index.
The contracts that can be created are almost endless. This possibility of variety is what gives derivatives their reputation for being complex financial instruments.
Financial derivatives have become an increasingly important part of the economy.
Q: Why use derivatives?
A: Derivatives are methods for shifting risk. Note that this is NOT reducing risk.
Here’s an example…
You are a building contractor. The person for whom you’re building a house wants a contract stating the total price up front. This is difficult because there are many cost uncertainties while a house is being built; one of these difficulties is the cost of materials.
As a contractor, you might enter into a derivative contract with a third party. If the price of materials goes up during construction time, then the third party makes up the difference. If the price doesn’t go up, the third party pockets the money you paid to obtain the derivative contract.
There are many more complex ways in which derivatives can be structured, but the basic principle is to shift risk from one party to another for a price.
Danger
Financial derivatives are:
- important to the operation of financial markets
- AND
- considered highly dangerous
Huge losses from improper use of derivatives are not uncommon.
Despite the negative image that derivatives have, they serve an important function — to shift risk and lower uncertainty in the financial marketplace.
Memory Jogger
Derivatives require: