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Derivatives (Future & Options)

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In finance, derivative means a security whose price is dependent on or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties, with a value determined by fluctuations in the underlying asset, which could be stocks, bonds, commodities, currencies, interest rates, and market indexes.

Futures contracts, forward contracts, options, and swaps are the most common types of derivatives. Since derivatives are contracts, almost anything can be used as a derivative's underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

A futures contract gives its buyer the obligation to purchase the underlying asset and the seller to sell (and deliver) it at a preset date. (If the futures holder liquidates his position prior to expiration, the delivery clause is voided, obviously.)

By contrast, an options contract, whether a call (buy an asset) or put (sell an asset), grants the holder the right - but not the obligation - to exercise the option. The holder is entitled to simply let the option expire without investing further.

Investors can enter futures contracts by paying upfront margin only (ignoring any commission), but an option always carries a cost - the 'premium'.

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