Derivatives

Now let’s shift from all these formulas and talk about derivatives. We’re first going to talk about stock options. The key part of a derivative is that its value is based on some underlying investment. We’re going to see how a stock option’s price is based on the underlying stock.

When you buy a stock option, you’re buying the right to either buy or sell a stock at a certain price at a future date. Maybe we want to buy a stock four months from now. Today we’re going to buy a stock option for four months from now.

There are a few key terms that you need to understand with options. You either have a call option or a put option. A call option means that you’re buying the right to buy shares of a company at a future date. A put option means you’re buying the right to sell shares at a future date.

The exercise price (i.e., strike price) is the price that the stock options allow you to either buy or sell the stock for at a future date. If the exercise price is $70 and you purchased a call option, then you’re allowed to buy the stock for $70, no matter what its actual price is. The stock option premium is what you pay to actually buy the stock option. For accounting purposes, we use the fair value of the options.