The Girl at the Bar

Derivatives come in all shapes and sizes, but at this juncture, it doesn't make sense to go into details. So, for my first pseudo-substantive post, I'll provide just enough ammunition for you to impress a girl at a bar. I mean a relatively nice watering hole, where an inebriated member of the opposite sex may actually be intrigued by the word "derivative." Though I wouldn't necessarily call myself Don Juan, I've found that at such establishments derivatives have an exotic, almost dangerous appeal. If talk of these instruments won't necessarily get you laid, it should get your foot in the door -- the rest, I'm afraid, is up to you.

"So what do you do?" the girl will ask after you'll accidentally bump into her and strike up a conversation.
"Derivatives."
"Ooh, sounds complicated," and then she'll flutter her eyes. At this point, if you're lucky, she'll just go home with you. But it usually doesn't work that way. "I've always wondered what those were."
"Well, you know, they really are complicated."
"It's okay. Explain to me."
For whatever reason, she thinks she's now in Continuous Finance and you're Robert Merton. Unfortunately, having brought up the topic, you'll have no choice but to throw something back at her. "Fine, but trust me when I say I'm a bad explainer."
"Don't worry." She'll wink. In all likelihood, she wouldn't be able to tell whether you were full of shit or not, so you just need to sound smart. Still, for the sake of intellectual honesty, you might as well deliver a half decent answer.
"A derivative is a fancy bet," you'll begin. "In fact, a derivative can be a bet on pretty much anything. You can trade a derivative on a stock, a bond, a commodity, and even your Prada purse if you want. What matters is that the value of your trade is derived from an underlying asset."
"Huh? You really are a shitty explainer."
"Sorry, let me give an example. It's probably easiest to do it with stocks. You have any stocks you like?"
"Yeah, Saks. I work there, and they gave me some stock. But I'd rather have shoes."
"Okay, suppose you own 1 share of Saks stock, and it's worth $10. Suppose further that you think the fall collection has a lot of promise and the stock will go up to $15 in the near future. Now, you could just buy another share, but you may not have $10 to spend. So, instead, you could contract with another party for the option to buy a share at a certain strike price -- let's say $15. This call option, a type of derivative, would work in the following way: if Saks rises to $16, you will profit because you have the right to buy the stock at $15 and can then immediately sell it for $16; however, if Saks never reaches $15 before your option expires, your contract will be worthless -- you wouldn't want to buy a share for $15 when the stock is trading below that. Am I going too fast?"
"No, this kind of makes sense. So, you're saying that with an option, I could get the right to buy a stock at a certain price, and if the stock ends up above that price, I will make money; otherwise, I won't."
"Yeah, you have the hang of it."
"That seems cool. Why doesn't everybody just do that?"
"Well, it's risky. Suppose the option to buy the Saks stock for $15 is trading at $2. $2 is a lot less than $10, the price of the stock now, but it can end up being a bigger outlay than you think. See, when you trade a stock, you don't generally have to worry about losing all of your money. Yeah, the thing may go up or down 5 or 10% over a few months, but unless the company goes bankrupt (not out of the question for Saks), your stock won't plunge to 0. With options, it's different. If Saks doesn't end up above $15, when your option expires, what you paid $2 for will in fact be worth 0. So, there's a very real chance that you could lose 100% of your money. See, with options, percentage gains and losses can be magnified."
"Oh, I get it. Kind of like shopping at one of those discount outlets. You could end up with a really great pair of Jimmy Choos but run the real risk of picking up fake heels instead."
"I guess you could say that. The financial term is 'leverage.' Like a bargain shopper, you don't put down a lot of cash for something that may make you very happy yet could produce more pain than a botched pedicure."
"I see. Thanks. I think that's enough for one night."
"Yeah, I'm getting kind of tired myself." Then, you'll look into her eyes and make the move. "Any plans for the rest of the night?"
"Heading over to my boyfriend's place actually. Thanks for all the info, though."