Derivatives are financial instruments, the value of which is based on (or derived from) the price of another asset. This underlying asset can be a commodity, currency, stock, index, interest rate, or even another financial instrument. The key idea behind derivatives is that they allow market participants to gain exposure to the price movements of an asset without having to own it directly.
How do derivatives work?
Rather than buying the underlying asset itself, traders and investors use derivatives to gain exposure to its price movement or to hedge (protect) against adverse price movement. For example, a trader might use a derivative to profit from a rise or fall in an asset’s price, while a business might use it to protect against adverse price fluctuations in a currency or commodity it holds.
There are many types of derivatives, the most common being:
- Futures - Contracts to buy or sell an asset at a future date for a predetermined price, typically traded on a trading venue.
- Options - Contracts that give the right (but not the obligation) to buy or sell an asset in the future.
- Forwards - Similar to futures but customized and traded over the counter (OTC).
Why are derivatives used?
Derivatives serve several key purposes:
- Hedging: Investors and businesses use derivatives to reduce exposure to adverse price movement of an asset they hold or are expected to hold, or even as a way of protecting against adverse conditions affecting their commercial activities
- Speculation: Traders can take positions based on their expectations of market movements, and may magnify their exposure by using leverage.
- Access and Efficiency: Derivatives can provide access to markets or strategies that would otherwise be difficult or expensive to implement.
What makes derivatives different from spot trading?
In spot trading, you are buying or selling the actual asset at the current market price. In contrast, derivatives are contracts that give you exposure to the future value of an asset. This means you can gain exposure to market movements, often with less capital up front - but also with increased complexity and risk.
Derivatives are a foundational component of modern financial markets. They are used by everyone from individual investors to large institutions and are essential tools in managing risk, increasing liquidity, and enhancing investment strategies.
They can be used as trading strategies and risk management tools for professional and retail traders alike.
Investing involves risks. The value of investments can go up as well as down and you may receive back less than your original investment or lose your entire investment. Investing with leverage means the value of your investment fluctuates more than the price of the underlying asset. One Trading does not provide investment advice and investors should make their own decisions or seek independent advice.