Lock in a price today. Or buy the right to choose later.
The story so far The bike chain (Lessons 16.1 and 16.2) needs 100 tons of aluminum for frames in 6 months, and aluminum prices jump around. A rise could wipe out a year's profit. Meanwhile, you own 100 shares of the chain's stock at $26, and you think it could climb, or crash. Both problems have the same kind of tool: a contract about what happens next. This lesson shows how they work, and why they can protect you or burn you.
A derivative is a contract whose value comes from something else, like a stock or aluminum. Futures and options are the most common.
Companies use them to lock in prices and protect profits. Investors use them to protect portfolios, or to bet with less money up front.
A future is a promise to trade at a set price later. An option is the right, not the duty, to trade at a set price, and you pay for that right up front.
Derivatives traders at banks make markets in them. Risk managers at companies use them to hedge. Commodity traders deal in oil, metals and crops.
What you're looking at: a call option on the chain's stock. For a $200 price paid today, you get the right to buy 100 shares at $30 each any time until June. If the stock stays below $30, you just don't use it. That's what "right, not duty" means.
A contract whose value comes from something else.
Stocks and bonds are pieces of a company or a loan. A derivative is different: it's a contract about something else, called the underlying. When the underlying's price moves, the contract's value moves too.
Futures: locking in a price
A futures contract is a deal to buy or sell a set amount at a set price on a future date. Both sides must go through with it. Futures trade on exchanges like the CME in Chicago, for oil, metals, crops, stock indexes and more.
- The chain's futures
- It agrees today to buy 100 tons of aluminum in 6 months at $2,500 a ton: $250,000.
- If aluminum rises to $3,000
- The futures gain ($3,000 − $2,500) × 100 = $50,000, covering the higher price. The chain still pays about $250,000 in total.
- If aluminum falls to $2,000
- The futures lose ($2,500 − $2,000) × 100 = $50,000, but the metal is $50,000 cheaper. Still about $250,000.
Hedgers and speculators
The chain isn't trying to win; it wants a price it can plan around. Using a derivative to reduce a risk you already have is hedging. Using one to bet on a price, with no risk to protect, is speculating. Markets need both: speculators take the other side of hedgers' trades.
- Hedger
- The bike chain, which really needs the aluminum.
- Speculator
- A trader who sold the chain those futures, betting aluminum won't rise.
Options: the right, not the duty
An option gives its buyer a choice. A call option is the right to buy at a set price; a put option is the right to sell. The set price is the strike price, the last day is the expiration, and the price you pay for the option is the premium. One stock option contract covers 100 shares.
- Your call
- Strike $30, expires in June, premium $2 a share × 100 shares = $200.
- Stock at $36 in June
- Buy at $30, worth $36: ($36 − $30) × 100 = $600. Minus the $200 premium: $400 profit.
- Stock at $28 in June
- Why buy at $30? You don't. The option expires, and you lose the $200 premium, no more.
Break-even and leverage
A call starts making money only when the stock passes the strike plus the premium, its break-even. Options are a form of leverage (Lesson 13.1): a small amount controls a lot of stock, so the percent gains and losses are huge.
- Break-even
- $30 + $2 = $32.
- Stock goes $26 → $36
- Owning 100 shares: $2,600 becomes $3,600, $1,000$2,600 = about 38%. The call: $200 becomes $600, $400$200 = 200%.
- Stock goes $26 → $28
- Shares: up about 8%. The call: −100%.
What you're looking at: your profit in June at each stock price from $20 to $40. Blue is owning 100 shares bought at $26. Green is the $30 call bought for $200. The dashed line is zero profit. The dots show where you are at the price you pick.
A put as insurance
Worried your shares could crash? Buy a put. It's like insurance (Lesson 6.1): you pay a premium, and if the price falls below the strike, the put pays you back.
- The put
- Right to sell 100 shares at $24, premium $1 a share: $100.
- Put break-even
- A put gains as the price falls, so subtract: strike − premium = $24 − $1 = $23.
- Stock crashes to $15
- Your shares lose ($26 − $15) × 100 = $1,100. The put pays ($24 − $15) × 100 = $900. Total loss: $1,100 − $900 + $100 premium = $300, instead of $1,100.
Two minutes. Just listen.
Tap any line to jump to it.
Derivatives desk.
Eight questions from a derivatives desk. Each one gives you the numbers. One option contract is 100 shares. One try each.
What you're looking at: made-up contracts. Each lists the details, then asks one question.
The logic, step by step.
To work out any option at expiration, take four steps.
Step 1: Call or put?
- Your option
- A call, strike $30.
Step 2: Would you use it?
- Stock at $36
- Yes: buying at $30 beats $36.
Step 3: What's it worth?
- The call
- ($36 − $30) × 100 = $600.
Step 4: Subtract the premium
- Profit
- $600 − $200 = $400.
Worked example: should you protect your shares?
The chain reports earnings next month, and the stock could jump or crash. Here are the facts:
- You own: 100 shares bought at $26.
- A $24 put: costs $100 for 100 shares.
- A $30 call: costs $200 for 100 shares.
- Name your risk. You already own the shares, so your risk is a crash. That calls for a hedge, not a bet.
- Price the hedge. The put costs $100, about $100$2,600 = 4% of your shares' value.
- Check the worst case. With the put, the most you can lose is ($26 − $24) × 100 + $100 = $300, however far the stock falls.
- Skip the bet. Buying the call too would add a $200 speculation on top of shares that already gain if the stock rises.
- The answer. If a crash would really hurt you, the $100 put is cheap insurance. If you can live with the swings, keep the $100: like all insurance, most of the time it expires unused.
Desert seeds hedge their bets.
In deserts, some years bring rain and some bring none. Many desert annual plants don't let all their seeds sprout at once. Some sprout the first year; others wait in the soil for years. If one year is a drought, the waiting seeds survive. Biologists call this bet-hedging.
What you're looking at: an illustration, not data. Desert soil where some seeds from the same plant have sprouted this year, while others wait underground for a later rain.
Why this sticks. The waiting seeds are a put option: they give up some growth this year to make sure a bad year can't wipe the plant out. A good hedge costs a little every year so that no single year can ruin you.
The page you'd copy down.
- Derivative: a contract whose value comes from an underlying (stock, oil, aluminum, rates).
- Futures: both sides must trade at a set price on a set date. Chain locks aluminum at $2,500 a ton: about $250,000 either way.
- Hedging reduces a risk you have; speculating bets on a move.
- Call: right to buy. Put: right to sell. Strike, expiration, premium. 1 contract = 100 shares.
- Call profit = (stock − strike) × 100 − premium: ($36 − $30) × 100 − $200 = $400. Below the strike: lose the premium only.
- Call break-even = strike + premium: $32. Leverage: +200% or −100%.
- Put as insurance: $24 put for $100 caps the loss at $300 if the stock crashes. Put break-even = strike − premium: $23.
Fill in the blanks
Grab a friend or a study group.
Concert ticket option
One person sells another the right to buy a concert ticket at today's price next month, for $5. Next month, the ticket costs more or less. Who won?
Who hedges?
List five businesses, like an airline, a farm or a coffee chain. What price risk does each one face, and which futures could it use?
Draw the payoff
Each person draws the profit line for a call or a put on paper, then trades papers and checks the break-even.
Just you and your money.
These stay on this device. Nobody else sees them.
Exam-style questions.
Written the way a college exam would ask them. Each right answer on the first try is worth 10 xp.
On the job: you're a risk manager at an airline
Your airline will buy 1 million gallons of jet fuel in 3 months. The CFO wants a plan. Here's the situation:
- Fuel futures price for 3 months out: $2.50 a gallon.
- The airline's budget: built on $2.50 a gallon, or $2.5 million.
- Option 1: buy fuel futures at $2.50.
- Option 2: buy call options with a $2.60 strike, for a premium of $0.10 a gallon.
Your task: what does each choice cost if fuel ends at $3.20? And if it falls to $2.00? Which would you recommend, and why?
See a model answer
Futures, fuel at $3.20: fuel costs $3.2 million, the futures gain ($3.20 − $2.50) × 1 million = $700,000. Net $2.5 million. At $2.00: fuel $2.0 million, futures lose $500,000. Net still $2.5 million.
Calls, fuel at $3.20: fuel $3.2 million, the calls pay ($3.20 − $2.60) × 1 million = $600,000, premium $100,000. Net $3.2 − $0.6 + $0.1 = $2.7 million. At $2.00: the calls expire; fuel $2.0 million + $100,000 premium = $2.1 million.
To the CFO: futures give a fixed $2.5 million no matter what, which matches our budget exactly. Calls cost $100,000 up front and cap our cost at $2.7 million, but let us save if fuel falls. If our priority is hitting the budget, use futures. If we can afford a bit more risk for the chance of savings, calls are worth it.
You finished the whole course.
What you're looking at: a map of where this lesson fits in the course. Read it left to right: the lessons it builds on, this lesson in the middle, and the end of the course.
- Back · Unit 14Risk and return
- Back · Unit 6Insurance
- Back · Unit 16How trading works
- You are hereOptions and futures
- NextCourse complete
That's every lesson, from your first budget to options and futures. Everything ties together: the time value of money prices bonds, companies and options; risk and return set every discount rate; and every job on Wall Street does one piece of it. Go back to any lesson on the map to review.