How to Invest in Derivatives

••• new york stock exchange image by Gary from Fotolia.com

Investing using derivatives is a form of leverage in which the individual investor might make a significant profit from a relatively small investment. Although derivatives are riskier than individual stocks or bonds, they remain attractive to a wide number of investors because of the potential return. Options are perhaps the most widely traded type of derivative. An option is “a contract that gives the buyer the right to sell, but not the obligation to buy or sell, an underlying asset at a specific price on or before a certain date,” according to Investopedia.com.

How to Invest in Derivatives

Open an account at a discount or full-service brokerage, and indicate your intention to trade options within that account. Because options and derivatives are riskier than traditional buy-and-hold investing, some companies have additional requirements for that type of account.

Confirm you have stocks within your portfolio that you can write options on. Set the strike price for your covered call. The closer the strike price is to the current share price, the higher premium you will receive, but the greater the chance the option will trigger and you will have to provide that stock at the price.

Write a call option. When you write a call option you are offering the underlying stock for sale based on a specific price, known as the strike price within a specific time frame. If you own the underlying asset it is known as a covered call; if you do not own the asset it is known as a naked call.

By writing the call option you receive income from the premium charged for call. Writing covered call options is a good way to earn additional income from your investment portfolio.

Select the month you want the option to expire in. Again, the longer the time frame, the more income you will receive. But this also provides a longer period of time in which the stock might hit the strike price.

Sell your option into the market. You will receive income into your account as soon as the trade settles. Your goal is for the option to expire worthless in the buyer’s hands. The worst case for you is that your shares will be “called away” at the price set in your option. If this price is greater than what you purchased them at, you will still realize income from the covered call, and profit from the sale of the shares.

Tips

  • Writing covered calls is probably the easiest form of options to understand and execute. You should always seek out professional advice when investing.

About the Author

Since 2002 Mark Spowart has been working as a freelance writer and photographer in London, Canada. He has publication credits for writing and/or photography in Canada, The United States, Europe and Norway, with such titles as "The Globe & Mail," "The National Post," Canada News Wire, Sun Media and "Business Edge" magazine.

Photo Credits

  • new york stock exchange image by Gary from Fotolia.com