Derivatives · Beginner · 4 min

What is a derivative?

You can explain what a derivative is, name the main types and describe what they are used for, from hedging to speculation.

A contract on a price

Options, futures, CFDs, warrants, certificates. The world of derivatives has many names, and many of them sound designed to confuse.

Underneath, they share one simple idea: a contract whose value follows the price of something else. This lesson explains that idea, introduces the main types covered in this rubric, and shows why the same contract can reduce risk for one person and multiply it for another.

Hedge or speculate

A derivative is a contract whose value is derived from an underlying: the asset or value it refers to. Common underlyings are shares, stock indices, currencies, interest rates and commodities.

The main types in this rubric:

Options give the buyer the right, but not the obligation, to buy or sell the underlying at a set price by a set date. The seller takes on the obligation.
Futures oblige both sides to buy and sell a set amount at a set price on a future date. Most are traded on exchanges.
CFDs, contracts for difference, pay out the difference between the opening and closing price. They are traded over the counter with a provider.
Warrants and certificates are securities issued by banks, often with option-like or leveraged features.

Derivatives serve two very different purposes:

Hedging: reducing a risk you already have. The CFTC explains that futures markets developed so that producers and users of commodities could protect themselves against price changes.
Speculation: taking on risk to profit from price moves. Speculators also provide the other side for hedgers.

Most derivatives used by private traders work with leverage: a small amount of money controls a large exposure. That magnifies gains and losses, and some products can lose more than the money paid in. That is why this rubric starts with the core ideas before any product.

Same contract, two reasons

A fictional farmer expects to harvest 100 tonnes of wheat in autumn. In spring, wheat futures for autumn delivery trade at 220 per tonne.

The farmer sells futures for 100 tonnes at 220, locking in that price. If wheat falls to 180 by autumn, the gain on the futures offsets the lower price for the harvest.
A trader buys those same futures, expecting prices to rise. If wheat rises to 260, the trader gains. If it falls, the trader loses.

The contract is identical. For the farmer it reduces risk, for the trader it creates it.

Common mistakes

"Derivatives are only for gambling." They began as tools for hedging.
"Derivatives are safe if a bank sells them." Leverage and issuer risk still apply.
Ignoring the underlying. You need to understand what the price depends on.
Forgetting leverage. Small moves can mean large losses.

The takeaway

A derivative is a contract whose value depends on something else: a share, an index, a currency or a commodity. It can hedge risk or multiply it.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the derivative that gives its buyer a right, not an obligation.

Tap the chart.

An option buyer may exercise, but does not have to. A futures contract binds both sides.
2What is the underlying of a derivative?

Shares, indices, currencies, interest rates and commodities are common underlyings.
3A farmer sells wheat futures before the harvest. Why?

That is hedging, the original purpose of futures markets, as the CFTC explains.
4Why are many derivatives risky for private investors?

Leverage magnifies results. Some derivatives can lose more than the money paid in.

of 4 correct.