A derivative is a contract whose price and payoff are linked to something else, known as the underlying. That underlying might be a share, a commodity, a currency pair, an interest rate, a credit index or even a cryptocurrency.
Derivatives come in many forms, including futures, forwards, options, swaps and more packaged products. Some trade on exchanges with central clearing, others are negotiated privately over the counter. They can settle in cash or by delivering the underlying, and they may expire on a set date or roll indefinitely.
What makes a derivative different from owning the asset
Two things stand out. First, you can shape the exposure. You can take a view on direction, volatility or the spread between two prices without holding the underlying outright. Second, derivatives often use margin, so you post a fraction of the contract’s value as collateral. That creates leverage, which can magnify gains and losses.
Derivatives also have rules about expiry and settlement. A physically settled contract might deliver barrels of oil or a basket of shares at maturity. A cash-settled one pays the difference between the market price and the contract price. Exchange-traded futures are marked to market each day, with profits and losses credited in cash. Over-the-counter contracts depend on the terms you agree with the counterparty and any collateral arrangements.
The main types you will see and how they work
- Futures and forwards. A future is a standardised agreement traded on an exchange to buy or sell an underlying at a set price on a set date. A forward is the same idea but negotiated privately. Futures are cleared, margined daily and easier to trade in and out of. For example, currency futures let you lock in an exchange rate for a future month.
- Options. An option gives you the right, not the obligation, to buy or sell the underlying at a strike price by or on a stated date. You pay a premium upfront. A call option is the right to buy, a put is the right to sell. Option payoffs are non-linear. Time value decays as expiry nears, and sensitivity to the underlying price and volatility is captured by metrics known as the Greeks.
- Swaps. In a swap, two parties exchange cash flows. The most common is an interest rate swap where one side pays fixed and receives floating, or vice versa. Currency swaps exchange principal and interest in two currencies. These are usually over the counter and rely on collateral and documentation between the parties.
- Other wrappers. Contracts for difference, warrants, structured notes and perpetual futures in crypto markets are also derivatives. Exact features vary by provider and venue, including how margin, funding and settlement are handled.
Some contracts are linear, meaning profit changes roughly pound for pound with the underlying. Futures and forwards are in this camp. Others are convex. Options can gain disproportionately when the underlying moves far enough in your favour, but can expire worthless if it does not.
Why do traders and companies use derivatives
Hedging. A business can offset a risk it already has. An airline might lock in fuel costs with oil futures. An exporter with dollar revenues could sell USD forward to protect the sterling value of cash flows. These positions smooth outcomes, though they can also forgo some upside.
Speculation. Traders use derivatives to express a view with less capital than buying the asset outright, or to bet on volatility rather than direction. Options allow limited downside with defined premium outlay. Spread trades and calendar trades aim to profit from relative moves.
Arbitrage and price discovery. If a derivative looks mispriced versus the underlying or versus another contract, arbitrage strategies may lock in a small edge. The flow of trading also feeds into price discovery for the underlying markets.
How pricing, margin and leverage fit together
Derivative prices are anchored by no-arbitrage logic. For futures, the fair price often reflects the cost of carry, which combines financing costs, any income from holding the asset and storage or borrow fees. If carry is positive, futures tend to be above spot for the same delivery month. If the asset pays a high income or is costly to store short term, the relationship can flip.
Option prices depend on the underlying price, strike, time to expiry, interest rates, expected dividends and implied volatility. Models such as Black-Scholes and binomial trees give a theoretical value, but actual prices also reflect supply, demand and liquidity. Measures like delta, gamma, theta and vega help traders understand how sensitive an option is to moves in price, time and volatility.
Leverage comes from margin. With a future, you post initial margin and then variation margin as the market moves, which realises profit and loss each day. If losses push your account below maintenance levels, you may face a margin call. Option buyers pay the premium upfront and have no further obligation. Option sellers collect premium but may need to post margin because their risk can be large. Over-the-counter trades are supported by bilateral or central collateral agreements, which can change the funding cost and risk.
Risks and practical pitfalls
- Leverage risk. Small price moves can create outsized gains or losses. A gap through a stop can exceed posted margin.
- Basis risk. Your hedge might not move perfectly with the risk you are trying to offset. A jet fuel bill hedged with crude oil futures will not be a perfect match.
- Liquidity and slippage. Some contracts are thinly traded or widen out at volatile times, which can make entry and exit costly.
- Counterparty and clearing risk. Exchange-traded contracts use central clearing to reduce this, while over-the-counter deals rely on the other party and any collateral terms.
- Model and parameter risk. Option values change with volatility and time. Misjudging these inputs can lead to pricing or risk errors.
- Roll and term structure. If you need ongoing exposure, you may have to roll futures at a gain or loss depending on whether the curve is in contango or backwardation.
Rules on margin, reporting and the tax treatment of derivative gains and losses differ by country and can change. Platform features and fees also vary by provider, especially for over-the-counter products. Read the contract specs and terms before trading.
Worked examples you can scale up
Futures hedge. A farmer expects to harvest 50,000 bushels of wheat in three months and fears prices could fall. They sell a futures contract now at a set price. If spot prices drop by harvest, the wheat sells for less but the short future gains, offsetting the loss. If prices rise, the hedge reduces the upside, but revenue is more predictable.
Simple call option. You buy a one-month call on a share with a strike of 100 for a premium of 5. At expiry, if the share is 112, the option is worth 12, so profit is 7 after the premium. If the share finishes at 98, the option expires worthless and the loss is limited to the 5 paid.
Interest rate swap. A company with floating rate debt worries that rates might rise. It enters a pay-fixed, receive-floating swap for the same notional and term. If rates increase, higher interest on the loan is offset by receiving more on the swap. If rates fall, the swap becomes a cost, but the firm has locked its effective rate.
These small numbers scale. The logic is the same whether you are hedging a household foreign currency transfer, managing a pension fund’s duration or trading volatility on a crypto index.