While combing through financial publications, you may have come across stock derivatives. It probably triggered horrific memories of college calculus class. Don't worry! Understanding stock derivatives is a lot easier than attempting calculus.
At one point, derivatives were financial instruments reserved for eccentric financial gurus. Few people understood derivatives, and even fewer could actual employ them. The collapse of Enron highlighted derivatives and their complexities. Basically, Enron's financial executives created offshore subsidiaries of subsidiaries of subsidiaries. The general public learned that derivatives are risky, and caused a giant corporation to go bankrupt.The root of derivatives is to derive, which means "to take origin from." Stock derivatives are therefore creations from stocks. The most easily understood financial derivatives are options. An option is a representation of the underlying stock. Therefore, an IBM option is the option to buy IBM's stock. The option is only worth as much as the market perceives it as.Originally, derivatives were used to reduce risk rather than to increase leverage and heighten exposure to risk. You can use options to reduce the volatility and risk of your portfolio. A simple option strategy is to buy a put on a stock in which you're long in your portfolio. If the stock declines, you'll profit from your option. If it increases, you'll make money on your stock. Professionals have used derivatives to protect their assets for decades. It was only until recently where complex derivatives were used to avoid taxes, and overexaggerate earnings.
