Yeah so in finance we have really weird names for things:
Black-Scholes Option Pricing Model
Dorsey Wright Funds
Duration & Convexity
So, in this context “derivatives” are no different.
The official Webster’s dictionary meaning of a derivative is:
1. something that is based on another source.
But in finance though?
2. an arrangement or instrument (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset.
Now again…. What the f**k does that mean?
This sh*t sounds like those Russian dolls that has a dolls inside with a doll inside. Remember those? OD SPOOKY.
So let’s try to break this thing down real quick. In some street terms that we can all understand.
If your teenage years were like mine you probably blew a substantial amount of the money you earned on sneakers. But if you were a bum like me, to get your hands on sneakers you had to wait on line.
But on top of waiting on line you had to get a ticket. Now with this TICKET you had the actual chance to buy the sneakers you were waiting on line for. If these were some lit ass sneakers (let’s say some Playstation Air Force 1’s) then there were not many tickets available and you basically had to be Michael Jordan’s kin to even get a chance to grab a ticket to get those sneakers at retail. THE STRESSSSSSS.
Now if you were a collector/flipper like some people I know, sometimes you sold your spot in line, or sold your ticket, and you increased the price of the ticket based on which ticket you had or how expensive the sneaker was or how rare it was. See in these streets tickets have power. Either way…. The TICKET is a DERIVATIVE of the SNEAKER.
Yeah I figured you needed like 3 of those just to understand what happened. See finance is real life my guy don’t play no games with it shit is pervasive.
Anyway in case you missed it… The sneaker is the underlying asset and the ticket is the derivative. The ticket represents the sneaker but IT IS NOT the sneaker. But the value of the ticket is DETERMINED by the value of the sneaker.
I hope you caught that. If you didn’t… Text me.
This is exactly how derivatives work…. But derivatives are EVERYWHERE. And this is possible because claims to property are in essence property themselves (this is some real LAW x Plato logic shit right here and I could blow this whole post by going into it but I won’t).
So where are derivatives actually?
Stocks have derivatives… They’re called “Options”
You can buy a call option: A right to BUY the stock at a certain price.
You can also buy a Put option: A right to SELL the stock at a certain price.
Notice how you can buy both of these options WITHOUT owning the stock at all. Shit crazy right?
What’s crazier is you can sell your option (just like you can sell your ticket) but of course (like most things in life) your option expires. When your option expires… It has no value (it’s basically dead). Sometimes options live for a week, a month, and with some stocks a year. So play smart if you gonna play this game.
Buying and selling these options is called “Options Trading”. I like to use options to “Hedge” my investments in companies. Hedging is basically figuring out ways to limit your losses or your exposure to risk.
For example: I’ll buy shares of Facebook stock at $65 a share. Then buy a put option (for $2 bucks) at a strike price of $62. This Put Option is like buying insurance on my stock (you pay a $2 premium for the insurance). If my stock goes up…. Great I’ll just let my Put option expire and move on with my life.
If my stock goes down significantly (let’s say down to $50) then I’ll just exercise my Put option (at $62) and Sell my shares at that price to limit my losses. Just saved myself a loss of $12 a share.
It’s a great way to avoid mayhem (lmao see what I did there?)
How do I buy Options?
Most trading platforms allow their customers to buy options on margin. (I DO NOT RECOMMEND TRADING ON MARGIN (AKA BORROW). ACTUALLY I RECOMMEND AGAINST THAT FAM DON’T EVER BORROW MONEY TO TRADE BRO DON’T DO IT). If you have the cash, just purchase your option and make sure you have the money to exercise at the moment you need to.
If you’re on Robinhood you can sign up and get cleared for options trading. It’s a great place to get started and use little amounts of money to practice. Don’t OD though. Please. I’m serious. This is a learning activity y’all not the casino.
So look. I know this was kinda crazy. But it’s far from over. Instead of teaching y’all about Bond derivatives (Interest Rate Caps and Floors). I’m going to save that for next week. Imma drop that heat tho I got you…. (Tracy said dropping the Bond derivatives with the stock derivatives is too crazy)
As always… If you have any questions… Text me.
And most importantly,
Keep Stackin’ that paper y’all,
Disclaimer: Please use your own due diligence before making any investment decisions. Past performance does not guarantee future results.