What does it mean for a contract to derive its value?
Every instrument you have met so far is a thing you hold. A share is a slice of a company. A bond is a promise from a borrower. An ETF is a basket of both. Each has value because of what it is.
A derivative is different in kind. It is not a thing you own — it is a written agreement between two parties whose payoff is calculated from the price of something else. That something else is the underlying. Remove the underlying and the contract has nothing to compute from; it is an empty formula.
The formula, not the asset
Suppose two parties sign this agreement:
At the end of March, for every dollar the price of crude oil is above $80, side A receives $50 from side B. For every dollar it is below $80, side A pays $50 to side B.
Run the arithmetic:
- Oil ends at $86. Difference: $86 − $80 = $6. Payment: 6 × $50 = $300 from B to A.
- Oil ends at $77. Difference: $80 − $77 = $3. Payment: 3 × $50 = $150 from A to B.
- Oil ends at exactly $80. Nobody pays anybody.
Notice what did not happen. No barrel of oil moved. Neither party owned oil before the contract or after it. No oil company received a cent. And yet real money changed hands, and the amount was decided entirely by the oil price. That is the whole idea of a derivative.
Three consequences that follow immediately
1. It is a two-sided contract, not an asset class. Every dollar one side gains, the other side loses, to the cent. A share can rise for both of us at once because the company grew. A derivative cannot — between the two counterparties it nets to zero, before costs.
2. Being "short" is as natural as being "long". To bet against a share you must borrow one and sell it, which is awkward. In a derivative, the short side is simply whoever signs the other line of the same page. Symmetry is built in.
3. You get exposure without ownership. A German exporter can neutralise a currency risk without opening a foreign bank account. An airline can fix a fuel cost without building a tank farm. This separation of economic exposure from ownership is what makes derivatives genuinely useful — and, when the exposure is large relative to the capital behind it, dangerous. Both halves of that sentence get their own unit later.
The vocabulary you now need
- Underlying — the thing whose price drives the payoff (a share, an index, a bond, a currency pair, an interest rate, a commodity, even another derivative).
- Long / short — the side that gains when the underlying rises / falls.
- Notional — the reference quantity used to scale the payments ($50 per dollar, 1,000 barrels, $100 million). It is not money paid.
- Expiry or maturity — the date the contract resolves.
- Settlement — how it resolves. Cash settlement pays the difference in money; physical settlement actually delivers the underlying. Most financial derivatives are cash settled.
In the data
Apple's listed options are below, in the EODHD Terminal. Every line of that chain names the underlying, a strike and an expiry date, and carries its own prices: the contract and the share it derives from are two separate instruments tied together by the name.
Open AAPL.US — options in the EODHD Terminal
Two things follow. Only a minority of listed shares have options written on them at all. And each contract is born on its listing day and dies at expiry, while the share's price history runs on without a break, so the two histories never line up day for day.
Try it now
- Start with the underlying on its own. A year of continuous WTI crude is below — an ordinary price series, the same kind any index or share would give you.
- Pick any two dates, treat the earlier price as the agreed reference and the later as the settlement price, and Measure between them. Compute the payoff of the contract above at $50 per dollar of difference, and write down which side paid.
- Note the thing that matters most: the contract you just priced has no chart of its own anywhere. It inherited every number from the one above. That inheritance is the definition.
Nothing here is a suggestion to enter such a contract. This is the grammar of the instrument, not a proposal to use it.