*Guest post by The Duomo Initiative*

In the financial world, a derivative is a financial instrument that's based on an underlying asset or group of assets, such as stocks, bonds, commodities, currencies, or interest rates. The value of a derivative is based on the changes in value of the underlying asset. The most common types are options, futures, forwards, and swaps.

There are many different uses for derivatives. In the case of options, they give the option-holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (strike price), at or before a specified expiration date.

Let's walk through an example together to help you understand how options are used.

The diagram below shows what usually happens when you buy shares in a company in the regular way. In this case, we're buying 100 sahres of the company.

We can see our entry price was at £25 per share.

Therefore, if the price moves up to £30 (moving to the right along the x axis) we can use the green line to find that we've made a profit of £500.

On the other hand, if the share price fell to £20 (moving to the left along the x axis) we can use the green line to find that we've made a loss of £500.

The main thing to note here is that the profit or loss of the position is linear to the movements in the share price.

Now let’s look at the same trade using options.

We'll start with a call option. This gives us the right to **buy **a certain amount of the underlying asset, so we would be profiting from the price increasing.

Let's take a look at how this changes the diagram:

In this example, we're buying a call option at a strike price of £25 per share. This means, we have the right (but not the obligation) to buy 100 units of the underlying asset for £25 by a specified date in the future, regardless of what the actual price is in the market at that time.

However, you may notice in the diagram that if the price of the underlying asset is £25 we actually make a loss of £500. Why do you think that is?

It's because this is the cost we're paying for that option. When we buy an option, we pay an upfront cost known as a 'premium'. In this example, that cost is £500 for 100 shares.

You can think of this in a similar way to paying an insurance premium; you make a relatively small payment upfront in order to gain from a larger payout if certain criteria are met.

Therefore, if our strike price is £25 and the market price is £25, we haven't made a profit or loss on the position, but we have made a loss of £500 on the premium.

If the price rises to £30, it means it's above our strike price by £5 and we would be making a £500 profit on the position. But after we take away the cost of the premium, we're at breakeven overall.

So we can see, if the price of the underlying asset moves above our strike price, we are making a lower amount of profit than if we had simply bought the underlying asset since we've also paid a premium.

On the other hand, if the price of the underlying asset declines, rather than making a bigger loss like we would if we bought the shares, the most we can ever lose is the £500 we paid for the premium.

We can also take a similar approach if we want to make money from the price of the underlying asset going down. To do that, we would buy a put option.

If you look at the diagram below, we have the opposite situation to call option. If the price declines, we make more profit. If the price rises, the most we can lose is our £500 premium.

Buying a put would be similar to taking a short position in an asset.

As you can see in both diagrams, buying a call or a put can offer benefits to risk management when compared to trading traditional shares. Because from the get-go, you know exactly what your maximum loss will be; the premium.

There are two sides to every trade, and in order for a trader to buy a call or a put, there needs to be a counter-party. However, this can be very risky if used incorrectly.

Let’s take a look at the diagram for selling a call:

The first thing you may notice is that there is only limited upside, but there’s unlimited downside, this is what can make selling options particularly risky.

If you are selling a call, you are expecting the price of the underlying asset to decrease. However, this time your profit is based on the premium that you will be charging the buyer.

Finally, you can also sell a put which will look like this:

This time you are expecting the price of the underlying asset will decrease. Like the previous diagram, your upside is limited as you're only profiting from the premium whereas your downside can continue until the price of the underlying asset reaches £0.

Unlike buying an option where there is no obligation to exercise, a seller is obligated to sell the underlying asset to the buyer if they choose to exercise the option.

Both call and put options can be classified in another way too based on whether they're American or European style options.

American options can be exercised anytime before the expiration date, whereas European options can only be exercised on the date itself.

As we go through this series, we'll discuss more of the specific benefits of options. But let's wrap up this article with an overview.

There are several reasons why options are such a popular derivative.

Firstly, they offer limited risk when buying options, since you know the most you can lose is the premium.

Secondly, they offer more flexibility for using different strategies to manage risk, hedge positions, and profit from the markets. As we’ll cover in some modules later, there are many strategies you can use.

Finally, they offer access to leverage. This means you can increase your potential returns compared to buying the underlying asset. However, this could also result in bigger losses.