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Essential Option Strategies by J. Kinahan

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Chapter 3Know the Underlying

The global financial crisis of 2007–2008 is considered by many economists as the worst financial catastrophe since the Great Depression of the 1930s. A number of large global financial institutions were near the brink of collapsing before national governments offered bailouts. The housing market collapsed, and equity markets around the globe were left reeling. When the dust settled, experts scrambled to find reasons to explain the course of events. Some partially blamed the financial debacle on complex financial products called derivatives.

It's important to note, however, that the types of derivatives that created problems for financial institutions during the crisis are very different than those I trade, or that most brokerages would allow you to trade, and the ones I cover throughout this book. The typical definition of a derivative is any instrument that has its value derived from another asset. It covers a wide range of different types of instruments.

A futures contract is a derivative because its price is driven by the value of the commodity, index, or equity. For instance, S&P 500 futures derive their values from the S&P 500 Index. The futures are the derivatives, and the S&P 500 Index is the underlying index.

Relatively new instruments, including credit default swaps, were among the derivatives that sent shock waves through financial institutions in 2007–2008. They were structured by a handful of firms and traded over-the-counter between ...

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