The Derivative Scoop

Q: What are derivatives? - Z.S., Salisbury, Md.

A: "Derivatives" include options, futures contracts, warrants and more. Some are very creative financial instruments based on other instruments. While shares of stock represent real ownership stakes in real companies, derivatives often represent contracts, not assets. They derive their value from the performance of other assets, such as stocks, bonds or commodities.

Derivatives permit sophisticated investors to hedge their bets, engage in arbitrage (profiting from differences in prices), lock in prices and use leverage. For example, several derivatives may be based on a single bundle of home mortgages, with one representing the interest payments and another representing principal payments. Since they would react differently to interest rate changes, they will each likely appeal to a different kind of investor.

Derivatives are typically used by large, institutional investors to boost their overall return or to hedge against risk in their portfolios. They can be very risky, though, and when used aggressively can result in investors losing more than their initial investment. Even some Nobel Prize winners have lost big money on derivatives.

Q: How do I determine my cost basis in a stock and my gain when I sell it?

- L.K., St. Joseph, Mo.

A: Imagine that you buy 100 shares of International Alphabet Corp. (ticker: ABCDE) for $30 each, paying a $15 commission. Your cost basis is the purchase price ($3,000) plus the commission, or $3,015. The basis per share is $3,015 divided by 100, or $30.15. If you eventually sell the shares for $40 each, or $4,000, subtract the $15 commission and your proceeds will be $3,985, or $39.85 per share. Your taxable capital gain will be $970, or $9.70 per share.

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