What is a Derivative?

by Catherine Rein
(last updated June 2, 2009)

There are two major categories of derivatives, privately negotiated over-the-counter (OTC) derivatives and standardized, exchange-traded derivatives known as futures. Derivatives are agreements between buyers and sellers. They are valued based on the underlying asset, which could be a physical commodity, a company stock, a currency or just about any other tradable instrument.

Stock options are also a form of derivative. Trading options can be used in any type of market, up markets, down markets and sideways markets. Options can also be used to protect stock holdings from a decline in the market, produce income against a current stock holding and to benefit from a stock price rise by buying the stock.

You can learn to trade stock options by practicing on a virtual trading account. You are given a set amount of money to practice with. No actual money or investing is involved. You should be aware that trading stock options includes significant risk and is not for every investor. Practicing options trading is a good first step:

  1. Go to Chicago Board Options Exchange. The CBOE was founded in 1973 as the first U.S. options exchange. It was computerized in 1975 and currently has a daily volume of over 630,000 contracts. The CBOE can be found at www.cboe.com.
  2. Set Up a Virtual Trading Account. This takes just a few minutes to register and set up your own virtual trading account. The trading tool is found under "Trading Tools" and then "Virtual Trade Tool." You should take some time and go through the site's educational products on how to trade in options.
  3. 3. Start Your Virtual Trade. You should begin by researching your favorite stocks and placing orders for underlying stock positions. Options are bought and sold in lots of 100 shares, so underlying stocks are usually in lots of 100 shares. After you research your favorite options strategy, including covered calls or selling puts, place your virtual trade and watch the outcome. You can analyze the results by clicking on Analysis.

After learning to trade stock options, you can begin actual trading by opening a brokerage account. You will be required to get options approval before trading in options. Every brokerage is required to educate investors on the risks of options trading before allowing them to trade. You should continue to read and study education materials and ask for professional advice before beginning actual options trading.

Author Bio

Catherine Rein

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