Derivatives: Options (1)

Derivatives are financial instruments whose values depend on an underlying asset; their values are derived from the underlying assets, that is why they are called derivatives. The common types of derivatives include but are not restricted to forwards, futures and options. They are complex strategies that are used over a wide range of assets that have the potential of generating a random return over time. They can be combined in so many ways to confuse novice investors and can be a very quick way to make or lose money depending on how good the investor is, meaning that it is also a very quick way to lose money. Their complexity has been exploited so much that mundane conditions such as weather including level of rainfall or sunshine has been used as an underlying asset, simply because they have the potential of generating a random outcome.

In summary derivatives can be seen as a form of insurance cover for an underlying asset. This means that one investor act as an insurance investor, while another act as the insured investor. This is possible because while one investor sees an investment as a good one another sees the same investment as a bad one, so they bet against themselves.

I am not going to dwell on the intricacies involved in derivatives and I will concentrate on giving a very brief overview of the common derivatives that can be used on the stock market called options. I will also not go into details of how they work as it is wide enough to write a book on it.

It cannot be overemphasized that every option is held by two investors; the insurance investor and the insured investor. It should be noted that the two terms, insurance investor and insured investor are not used in the derivatives parlance. The insurance investor is called the short, while the insured investor is called the long. I am simply using those terms to make it easier to understand. It should be noted that at the start of the contract, the long pays the short a sum of money to initiate the contract called option premium. This arrangement happens only with options.

There are two types of options; they are the call and the put.

Options are owned simultaneously by two investors, the insurance investor (the short) writes the option, which is bought by the insured investor (the long). Depending on the rules of the exchange, one option covers a multiple number of an underlying asset e.g. 100 units of UBA. An option may cover 50, 100 or any number of shares of a particular stock.

We presently do not have derivatives in the Nigerian Capital Market.