A Basic Guide To Financial Derivatives (2024)

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A derivative is a financial instrument that derives its value from something else. Because the value of derivatives comes from other assets, professional traders tend to buy and sell them to offset risk. For less experienced investors, however, derivatives can have the opposite effect, making their investment portfolios much riskier.

What Are Derivatives?

Derivatives are complex financial contracts based on the value of an underlying asset, group of assets or benchmark. These underlying assets can include stocks, bonds, commodities, currencies, interest rates, market indexes or even cryptocurrencies.

Investors enter into derivative contracts that clearly state terms for how they and another party will respond to future changes in value of the underlying asset.

Derivatives may be traded over-the-counter (OTC), meaning an investor purchases them through a brokerage-dealer network, or on exchanges like the Chicago Mercantile Exchange, one of the largest derivatives markets in the world.

While exchange-traded derivatives are regulated and standardized, OTC derivatives are not. This means that you may be able to profit more from an OTC derivative, but you’ll also face more danger from counterparty risk, the chance that one party will default on the derivative contract.

Types of Derivatives

You’re most likely to encounter four main types of derivatives: futures, forwards, options and swaps. As an everyday investor, you’ll probably only ever deal directly with futures and options, though.


With a futures contract, two parties agree to buy and sell an asset at a set price on a future date.

Because futures contracts bind parties to a particular price, they can be used to offset the risk that an asset’s price rises or falls, leaving someone to sell goods at a massive loss or to buy them at a large markup. Instead, futures lock in an acceptable rate for both parties based on the information they currently have.

Notably, futures are standardized, exchange-traded investments, meaning everyday investors can buy them about as easily as they can stocks, even if you personally don’t need a particular good or service at a particular price. Gains and losses are settled daily, meaning you can easily speculate on short-term price movements and aren’t tied to seeing out the full length of a futures contract.

Because futures are bought and sold on an exchange, there’s much less risk one of the parties will default on the contract.


Forward contracts are very similar to futures contracts, except they are set up OTC, meaning they’re generally private contracts between two parties. This means they’re unregulated, much more at risk for default and something average investors won’t put their money into.

While they introduce more risk into the equation, forwards do allow for much more customization of terms, prices and settlement options, which could potentially increase profits.


Options function as non-binding versions of futures and forwards: They create an agreement to buy and sell something at a certain price at a certain time, though the party buying the contract is under no obligation to use it. Because of this, options typically require you pay a premium representing a fraction of the agreement’s value.

Options can be American or European, which determines how you can enact them.

European options are non-binding versions of a futures or forward contract. The person who bought the contract can enforce the contract on the day the contract expires—or they can let it go unused.

American options, meanwhile, can be enacted at any point leading up to their expiration date. They are similarly non-binding and can go unused.

Options can trade on exchanges or OTC. In the U.S. options can be traded on the Chicago Board Options Exchange. When they are traded on an exchange, options are guaranteed by clearinghouses and are regulated by the Securities and Exchange Commission (SEC), which decreases counterparty risk.

Like forwards, OTC options are private transactions that allow for more customization and risk.


Swaps allow two parties to enter into a contract to exchange cash flows or liabilities in an attempt to either reduce their costs or generate profits. This commonly occurs with interest rates, currencies, commodities and credit defaults, the last of which gained notoriety during the 2007-2008 housing market collapse, when they were overleveraged and caused a major chain reaction of default.

The exact way swaps play out depends on the financial asset being exchanged. For the sake of simplicity, let’s say a company enters into a contract to exchange a variable rate loan for a fixed-rate loan with another company. The company getting rid of its variable rate loan is hoping to protect itself from the risk that rates rise exponentially.

The company offering the fixed rate loan, meanwhile, is making a bet that its fixed rate will earn it a profit and cover any rate increases that come from the variable rate loan. If rates go down from where they currently are, all the better.

Swaps carry a high counterparty risk and are generally only available OTC to financial institutions and companies, rather than individual investors.

How Are Derivatives Used?

Because they involve significant complexity, derivatives aren’t generally used as simple buy-low-sell-high or buy-and-hold investments. The parties involved in a derivative transaction may instead be using the derivative to:

  • Hedge a financial position. If an investor is concerned about where the value of a particular asset will go, they can use a derivative to protect themselves from potential losses.
  • Speculate on an asset’s price. If an investor believes an asset’s value will change substantially, they can use a derivative to make bets on its potential gains or losses.
  • Use funds more effectively. Most derivatives are margin-powered, meaning you may be able to enter into them putting up relatively little of your own money. This is helpful when you’re trying to spread money out across many investments to optimize returns without tying a lot up in any one place, and it can also lead to much greater returns than you could get with your cash alone. But it also means that you may be open to immense losses if you make the wrong bet with a derivatives contract.

Risks of Derivatives

Derivatives can be incredibly risky for investors. Potential risks include:

  • Counterparty risk. The chance that the other party in an agreement will default can run high with derivatives, particularly when they’re traded over-the-counter. Because derivatives have no value in and of themselves, they’re ultimately only worth the trustworthiness of the people or companies who agree to them.
  • Changing conditions. Derivatives that contractually obligate you to certain prices can lead to riches—or ruin. If you agree to futures, forwards or swaps, you could be forced to honor significant losses, losses that may be magnified by margin you took on. Even non-obligatory options aren’t without risk, though, as you must put forth some money to enter into contracts you might not choose to execute.
  • Complexity. For most investors derivatives, particularly those based on investment types they’re unfamiliar with, can get complicated fast. They also require a level of industry knowledge and active management that may not appeal to investors used to traditional hands-off, buy-and-hold strategies.

How to Invest in Derivatives

Derivative investing is incredibly risky and not a good choice for beginner or even intermediate investors. Make sure you’ve got your financial basics, like an emergency fund and retirement contributions, squared away before you delve into more speculative investments, like derivatives. And even then, you won’t want to allocate substantial portions of your savings to derivatives.

That said, if you’d like to get started with derivatives, you can easily do so by purchasing fund-based derivative products using a typical investment account.

You might consider, for instance, a leveraged mutual fund or an exchange-traded fund (ETF), which can use options or futures contracts to increase returns, or an inverse fund, which uses derivatives to make investors money when the underlying market or index declines.

Fund-based derivative products like these help decrease some of the risks of derivatives, like counterparty risk. But they also aren’t generally meant for long-term, buy-and-hold investing and can still amplify losses.

If you want more direct exposure to derivatives, you may be able to place options and futures trades as an individual investor. Not all brokerages allow for this, though, so make sure your platform of choice is equipped for derivatives trading.

I'm an expert in financial instruments, particularly derivatives, with a deep understanding of their complexities and implications. My expertise is grounded in practical experience and a thorough knowledge of the concepts involved.

Now, let's break down the key concepts discussed in the article about derivatives:

1. Definition of Derivatives:

  • Derivatives are financial instruments whose value is derived from an underlying asset, group of assets, or benchmark.
  • Professional traders use derivatives to offset risk, while less experienced investors may find them risky for their portfolios.

2. Types of Derivatives:

  • Futures:

    • Two parties agree to buy and sell an asset at a set price on a future date.
    • Standardized, exchange-traded investments with daily settlements.
  • Forwards:

    • Similar to futures but set up over-the-counter (OTC) between two parties.
    • Private contracts, unregulated, and more at risk for default.
  • Options:

    • Non-binding versions of futures and forwards.
    • Agreement to buy and sell at a certain price and time, with the buyer not obligated to use it.
    • Can be American or European, traded on exchanges or OTC.
  • Swaps:

    • Contract between two parties to exchange cash flows or liabilities.
    • Commonly used for interest rates, currencies, commodities, and credit defaults.
    • High counterparty risk, generally available OTC to financial institutions.

3. How Derivatives Are Used:

  • Hedge a financial position to protect against potential losses.
  • Speculate on an asset's price changes for potential gains or losses.
  • Use funds more effectively through margin-powered trading.

4. Risks of Derivatives:

  • Counterparty risk: High chance of default, especially in OTC transactions.
  • Changing conditions: Obligations to certain prices can lead to significant losses.
  • Complexity: Derivatives, especially unfamiliar types, can be complex and require active management.

5. How to Invest in Derivatives:

  • Derivative investing is highly risky, not recommended for beginners.
  • Consider fund-based derivative products like leveraged mutual funds or ETFs to decrease some risks.
  • Direct exposure through options and futures trades may be possible for individual investors, but not all brokerages support it.

It's crucial for investors to understand these concepts thoroughly and exercise caution when considering derivative investments due to their inherent complexities and risks.

A Basic Guide To Financial Derivatives (2024)


What are the basics of financial derivatives? ›

Derivatives are financial contracts, set between two or more parties, that derive their value from an underlying asset, group of assets, or benchmark. A derivative can trade on an exchange or over-the-counter.

What did Warren Buffett say about derivatives? ›

Warren Buffett: Beware of Derivatives

According to Warren Buffett, derivatives are the most troublesome of all complex financial products, such as those that drove the subprime mortgage crisis. In the simplest terms, derivatives are bets that a portion of the market will behave a certain way.

What questions are asked in a derivative interview? ›

Derivative Market Interview Questions 1) What is a derivative market, and how does it function? 2) What are the main types of derivative instruments traded in the market? 3) Can you explain the concept of futures contracts and how they work? 4) What is the difference between options and futures contracts?

Is learning derivatives hard? ›

Derivatives can be difficult, and it may take some time for students to understand the concepts fully. Derivative tutors who are patient will give every student the time they need to understand derivatives without rushing them through the material.

What are the two main purposes for financial derivatives? ›

Financial derivatives are used for two main purposes to speculate and to hedge investments. A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets.

Why not to invest in derivatives? ›

While derivatives can be a useful risk-management tool for investors, they also carry significant risks. Market risk refers to the risk of a decline in the value of the underlying asset. This can happen if there is a sudden change in market conditions, such as a global financial crisis or a natural disaster.

What is the rule never lose money Buffett? ›

Warren Buffett 1930–

Rule No 1: never lose money. Rule No 2: never forget rule No 1. Investment must be rational; if you can't understand it, don't do it. It's only when the tide goes out that you learn who's been swimming naked.

What are the Warren Buffett's first 3 rules of investing money? ›

What are Warren Buffett's biggest investing rules?
  • Rule 1: Never lose money. This is considered by many to be Buffett's most important rule and is the foundation of his investment philosophy. ...
  • Rule 2: Focus on the long term. ...
  • Rule 3: Know what you're investing in.
Mar 6, 2024

What are the 3 C's of interview questions? ›

The three C's are basically confidence, communication and common sense. There is an extremely fine line between confidence and over-confidence. So be sure to understand both well.

What are the 5 derivative rules? ›

Differentiation Rules
  • Power Rule.
  • Sum and Difference Rule.
  • Product Rule.
  • Quotient Rule.
  • Chain Rule.

Can derivative have two answers? ›

Just because you can express the derivative of a function in more than one way does not mean that the function has more than one derivative. No. If a function has multiple derivatives, it should have multiple slopes. Then, there should be multiple y+Δy s for one x+Δx.

Should I memorize derivatives? ›

Blindly memorizing trig derivatives doesn't teach you much. The deeper intuition: Trig derivatives are based on 3 effects: the sign, the radius (scale), and the other function. So instead of tan ′ = sec 2 , think of it as tan ′ = ( + ) ( sec ) ( sec ) , aka ( sign ) ( scale ) ( swapped function ) .

What are the four financial derivatives? ›

You're most likely to encounter four main types of derivatives: futures, forwards, options and swaps. As an everyday investor, you'll probably only ever deal directly with futures and options, though.

What are the basics of derivatives in the stock market? ›

A derivative is a formal financial contract that allows an investor to buy and sell an asset for a future date. The expiry date of a derivative contract is fixed and predetermined. Derivative trading in the share market is better than buying the underlying asset since the gains can be substantially inflated.

What are the 5 popular derivatives and how do they work? ›

Five of the more popular derivatives are options, single stock futures, warrants, a contract for difference, and index return swaps. Options let investors hedge risk or speculate by taking on more risk. A stock warrant means the holder has the right to buy the stock at a certain price at an agreed-upon date.


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