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Financial derivatives are investment instruments that allow an investor to benefit from the price movement of a specific security without immediately gaining ownership of the security. In this way, an investor can get involved with a security at a smaller cost that what it would cost to buy it outright. The two most common types of financial derivatives are options, which allow an investor the opportunity to buy or sell an underlying security, and futures, which obligate a contract-holder to buy the underlying security. Derivatives also differ in terms of the types of securities, which can include stocks, bonds, commodities, and foreign currencies, that underlie the contracts.
To get involved with some of the companies that dominate stock market, an investor must often put up a great deal of cash. Such an investment can often take a long time to come to fruition, though, meaning that the investor's assets and liquidity may not be immediately impacted. Financial derivatives provide opportunities for investors to be exposed to such stocks and other pricey assets at a fraction of the price and with much greater flexibility. The contracts are called derivatives because they derive their value from the performance of these underlying assets.
Options are among the most popular of all financial derivatives, especially since many employers offer stock options to employers. A basic stock option contract gives the owner the right to either buy, with a call option, or sell, with a put option, 100 shares of stock at a price known as the strike price. If the buyer of an option, who must pay a price to own the contract, can anticipate the price movement of the stock, he can benefit from the difference between the strike price and the eventual price of the stock.
Futures are financial derivatives similar to options in that one party can buy some underlying asset at some point in the future at a predetermined price. They differ from options though in that the buyer must buy the underlying asset at the time and price stipulated in the contract. There is no premium paid for the futures contract itself, which also makes it different from an options agreement.
It is important to note that stocks are not the only underlying assets used in financial derivatives. Just about anything that has some sort of value that can increase or decrease over time can be used in a derivative contract. For example, commodities like gold or silver are often the basis of futures contracts. Foreign currencies, which can rise or decrease in value when compared to each other, are also popular assets used by investors in futures agreements.
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