Q&A: Derivatives explained

Simon Gergel, UK equity income specialist at RCM, explains the basics of a derivative

What exactly are derivatives?

A derivative is any instrument where the price is derived from another asset. That is where the word derivative comes from. Originally these would have been, for example, farmers selling agricultural commodities and wanting to get a guaranteed price for their product in the market. They would sell it at the beginning of the year to actually deliver it at harvest time. In practice today there are two major types of derivatives, futures and options.

Talk us through futures

If I was an oil producer and I have a million barrels of oil I want to sell, I might agree to sell them at $50 a barrel in a year’s time. So I know exactly what price I’m going to get. The buyer of that futures contract has an exposure to the oil price over that following 12 months, and if in a year’s time the oil price is at $70 he’ll be buying oil at $50 from the contract and selling it at $70 and he’ll be making a $20 profit per barrel. Equally if the oil price has gone down to $30 he’ll be making a $20 loss because he’ll be buying at $50 and selling at $30. So the futures price will move around considerably with the price of oil in this instance.

And an option?

An option, is similar to a future except the buyer of the option does not have to take delivery of the oil but has the option of taking delivery of the product at the end of the year. Because he has that option it can be quite valuable so you might have to pay quite a considerable premium to get that option at the beginning of the year.

So the producer of the oil might be agreeing to write the option to sell oil, at $50 in a year’s time but he might receive a $10 premium from the buyer of the contract. At the end of the year if oil is $70 the buyer of the contract has the option of exercising the option, which he would do.

He would get the oil at $50, he would be able to sell it at $70 and he would have a $20 profit, but of course he’s paid $10 for that option, so his $20 would be reduced to $10 profit but he’d still make a lot of money on a $10 initial investment.

If the oil price was $30 at the end of the year the important point is the buyer of the option does not have to take delivery of the oil at $50 and so he does not lose that $20, but he has spent $10 to get that option.

Originally derivatives were mainly based on agricultural products. They have now moved onto a much wider range of products, everything from commodities to financial assets, stocks and shares, to property and real estate.

What is the difference between a call and a put option?

A call option gives the purchaser the right to buy shares whereas a put option gives the purchaser the right to sell the shares and, because of that, they have quite different characteristics.

Could you give me an example of how a call option works?

A call option gives the purchaser the right to buy a share at a certain price at a point in the future. So if a company’s share price is £1, and we are talking about shares clearly, and you have the right to buy the shares at £1.10 over the next three months, if at the end of the three month period the share price is, say, £1.20 you can buy the shares at 110p and make a 10p profit less whatever you have paid for that option premium. If the share price is below £1.10 you would not exercise it because the strike price is £1.10 so you would make a loss of whatever the premium was.

What about a put option?

A put is sort of the reverse. It is the right to sell the shares at a certain level. So let’s take the above example but imagine you had a put option to sell the shares at 110p. If the shares were above 110p you would not exercise this because you could sell them much higher than that in the market, but if they were below 110p, let’s say the shares were 90p, you could sell at 110p and you could pocket the difference, which is a 20p difference per share, less whatever the price of the option would be.