DERIVATIVES

Derivative

A contract whose value is derived from an underlying asset.

Hedge

Using a derivative to reduce risk (a farmer locking in a crop price).

Speculate

Using a derivative to bet on price direction.

Leverage

Controlling a large position with little capital.

Futures contract

A standardized

Forward contract

A customized

Clearinghouse

Guarantees performance of futures contracts.

CFTC

The Commodity Futures Trading Commission

Option

The right (not obligation) to buy or sell an underlying at a strike price by expiration.

Call option

The right to BUY at the strike (bullish).

Put option

The right to SELL at the strike (bearish).

Premium

The price paid for an option. One contract = 100 shares.

Option holder

The buyer; pays the premium; limited loss; large upside.

Option writer

The seller; receives the premium; a naked call writer faces unlimited loss.

In-the-money call

When the stock price is above the strike.

In-the-money put

When the stock price is below the strike.

American option

Can be exercised anytime before/at expiration.

European option

Can be exercised only at expiration.

Covered call

Owning stock and selling a call for income; caps the upside.

Protective put

Owning stock and buying a put as downside insurance.

Straddle

Buying a call and a put to profit from a big move in either direction.

Swap

A customized OTC contract where two parties exchange cash flows.

Interest-rate swap

The most common swap; exchange fixed for floating payments.

Credit Default Swap

CDS - insurance on a bond's default; central to the 2008 financial crisis.