The Ins and Outs of New Dow Derivatives

How, exactly, will the new derivative securities tied to the Dow Jones industrial average work? Here’s a primer:

* A futures contract is an agreement to buy or sell a specific investment at a specific price on a future date, which may be weeks, months or years away.

If the market price of the investment rises in that period, the futures buyer profits if he or she has locked in a lower purchase price. The seller, in turn, loses. If, on the other hand, the market price of the investment falls in the period, the buyer loses if he or she has already agreed to pay a higher price. The seller, in turn, wins.

The value of a Dow futures contract, which will trade on the Chicago Board of Trade (after regulatory approval), is expected to be about 10 times the market index. So one contract would be worth about $74,350 at current prices. However, futures can be purchased for relatively little money down--5% or less.

That use of leverage means that profits and losses on futures can be highly magnified--making them lucrative and also dangerous.

* An options contract gives an investor the right, but not the obligation, to buy or sell a specific investment at a specific price by a future date. As with futures, that date may be weeks, months or years away, depending on the contract terms.

The price of an option, paid by the buyer to the seller, is known as the premium. It is determined by the market, based on the contract terms and the price of the underlying security.

As with futures, whether an investor wins or loses with an option is a function of the nature of the bet and what happens to the market price of the underlying security over time. Also as with futures, profit potential can be huge. Unlike with futures, the buyer of an option can’t lose more than the premium he or she has paid the seller, because an option is just that--an option.

Dow index options will trade on the Chicago Board Options Exchange. They are expected to have a face value equal to the index, meaning about $7,435 at current prices.

* Perhaps the most popular new Dow derivative will be a fund, known as a unit trust, which will own the 30 Dow stocks and which will trade on the American Stock Exchange. It will exactly track the movement of the index, in 1/100th increments. So at current prices one share would be worth about $74.