Day traders are likely to come across three types of derivatives: options, futures, and warrants. Options and futures trade on dedicated derivatives exchanges, whereas warrants trade on stock exchanges.
Options
An option is a contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at an agreed-upon price at an agreed-upon date in the future.
An option that gives you the right to buy is a call, and one that gives you the right to sell is a put. A call is most valuable if the stock price is going up, whereas a put has more value if the stock price is going down.
Here’s one way to remember the difference: You call up your friend to put down your enemy.
For example, a MSFT 2012 Jan 22.50 call gives you the right to buy Microsoft at $22.50 per share at the expiration date on the third Friday in January 2012. If Microsoft is trading above $22.50, you can exercise the option and make a quick profit. If it is selling below $22.50, you could by the stock cheaper in the open market, so the option would be worthless.
You can find great information on options, including online tutorials, at the Chicago Board Options Exchange website.
Futures
A futures contract gives you the obligation to buy a set quantity of the underlying asset at a set price and a set future date. Futures started in the agricultural industry because they allowed farmers and food processors to lock in their prices early in the growing season, reducing the amount of uncertainty in their businesses.
Futures have now been applied to many different assets, ranging from pork bellies (which really do trade — they are used to make bacon) to currency values. A simple example is a lock in a home mortgage rate; the borrower knows the rate that will be applied before the sale is closed and the loan is finalized. Day traders use futures to trade commodities without having to handle the actual assets.
Most futures contracts are closed out with cash before the settlement date. Financial contracts — futures on currencies, interest rates, or market index values — can only be closed out with cash. Commodity contracts may be settled with the physical items, but almost all are settled with cash. No one hauls a side of beef onto the floor of the Chicago Board of Trade!
Warrants
A warrant is similar to an option, but it’s issued by the company rather than sold on an organized exchange. (After they are issued, warrants trade similarly to stocks.) A warrant gives the holder the right to buy more stock in the company at an agreed-upon price in the future.
A cousin of the warrant is the convertible bond, which is debt issued by the company. The company pays interest on the bond, and the bondholder has the right to exchange it for stock, depending on where interest rates and the stock price are. Convertibles trade on the stock exchanges.