Derivatives and Witches

Q What are derivatives? — Y.S., Dalton, Georgia

A Derivatives are financial contracts whose value is based on (“derived”) from something else, such as stocks, bonds, currencies, commodities, interest rates or even mortgages. Examples of derivatives include warrants, futures, swaps and options.

A share of stock represents a real ownership stake in a real company. A stock option, though, is a contract that helps you make (or lose) money based on the price of that stock. Meanwhile, several derivatives may be based on a single bundle of home mortgages, with one representing the bundle’s interest payments and another representing its principal payments. Since they will react differently to interest rate changes, they will each likely appeal to a different kind of investor.

Derivatives can permit investors to hedge their bets, engage in arbitrage (profiting from differences in prices), lock in prices and use leverage (investing with borrowed money), among other things. They’re typically used by large, institutional investors, and many are quite risky, causing investors to lose more than their initial investment. Derivatives are best avoided by many, if not most, investors.

*** Q What’s the “triple-witching” hour? — G.G., Tucson, Arizona

A Four times a year — in March, June, September and December — stock options, stock-index options and stock-index futures all expire on the same day. The last trading hour of that day is known as the triple-witching hour. The market can be extra-volatile then, as traders are running out of time to take any actions related to the expiring investments.

Remember that most options and futures are contracts based on short-term pricing rather than long-term business growth. The best way to build long-term wealth is via long-term investing — no witchcraft required. Want more information about stocks? Send us an email to foolnews@fool.com.