Comparing Stock Options to Other Derivative Securities

The market value of a stock option is primarily determined by the stock price on which it's based. So an option derives its value from the underlying stock. These types of securities are known as derivatives. To best understand option valuations, you should know more about other derivatives in the market, including commodities and futures contracts and a quasi-derivative — the exchange-traded fund (ETF):

• Commodities and futures: As with stock options, commodities and futures contracts are also agreements between two parties. The main distinction is that a stock option gives you rights as an owner while a commodities or futures contract obligates you regardless. That's an important distinction if you are already trading these securities.

Commodities are contracts that fix the price for a set amount of a physical item, such as gold or livestock. Each contract is scheduled to be executed on a pre-determined date unless you exit the agreement by trading out of the contract. So as with a stock option, a commodity contract locks in the price and quantity of an asset. Unlike an option, it identifies a specific delivery date.

• Indexes: An index is a tool used to measure prices for a group of stocks, bonds, or commodities. As a result, you derive an index value by using the price of the different components that make it up.

An index isn't a security, though. You can't buy one. What you can do is buy a security that tracks the ups and downs of an index, such as a mutual fund. A mutual fund often imitates changes in the index it tracks by owning the same mix of stocks, bonds, or commodities. You won't get a perfect one-for-one match with the index, but it works pretty well.

• Exchange-traded funds (ETFs): In the same way an index derives its values from its components, so does the index mutual fund. Another security that behaves similarly is the exchange-traded fund (ETF). It's similar to a mutual fund because it represents a partial investment in a basket of stocks, bonds, or commodities. Some people call it a quasi-derivative because not all ETFs actually hold the component assets of the index it tracks. Some of them do it using more exotic securities. ETFs differ from mutual funds because they can be traded throughout the day just like stocks.

• Stocks and bonds: When you buy a stock, you partially own the company's assets. Purchasing a bond makes you a part holder of the company's debt. Each comes with different rights, risks, and rewards.