Derivative
A derivative is a contract whose value comes from the price of something else — a share, index, currency, commodity or cryptocurrency — such as futures and options.
Futures, options, swaps and CFDs all share one idea: you trade a contract linked to an asset, not the asset itself. That link lets traders hedge, speculate with less capital or bet on moves in either direction — and it also brings leverage, expiry dates and counterparty questions that a plain share purchase does not have.
- Category
- Derivatives
- Reading time
- 4 min
- Also called
- Derivative contract, Derivative instrument
- Updated
Derivatives in plain words
A derivative’s performance is derived, at least partly, from an underlying asset, security or index; a stock option, for example, changes in value as the underlying stock moves.1
A derivative is a contract, traded on an exchange or privately, whose value comes from something else — a share, an index, a bond, a commodity or another reference.2
Common types are Futures Contract, Options, swaps and CFDs. Many use Leverage, so small moves in the underlying create large gains or losses.
How to evaluate a derivative, step by step
Identify the underlying
Know exactly which asset, index or rate the contract tracks.1
Read the contract terms
Check size, expiry, settlement method and tick value.
Know your obligation
A futures contract obliges both sides to perform at the agreed price; an option buyer has a right, not an obligation.2
Calculate the exposure
Multiply contract size by the underlying price to see your full Exposure.
Check margin and leverage
Understand Margin requirements and how a Margin Call could arise.
Plan the exit
Decide where you close, roll or let it expire before you enter.
Worked examples
Example 1 — Exposure from a small deposit
10× leverageA futures contract covers 100 units of an index priced at $500. Margin required is $5,000.
| Exposure | 100 × $500 = $50,000 |
| Leverage | $50,000 ÷ $5,000 = 10× |
You control the full contract value with a fraction of it as margin, because the contract’s value is derived from the underlying.2
Example 2 — A 2% move against you
−$1,000The same index falls 2% while you are long one contract.
| Loss | $50,000 × 2% = $1,000 |
| Share of margin | $1,000 ÷ $5,000 = 20% |
A small move in the underlying became a large hit to your deposit — leverage cuts both ways.
Example 3 — An option’s limited loss
−$200 (capped)You buy 1 call option on 100 shares for $2.00 per share. It expires worthless.
| Premium paid | $2.00 × 100 = $200 |
| Maximum loss | $200 |
As a buyer you had the right but not the obligation to buy, so your loss was capped at the premium.3
Derivative vs. owning the asset
| Aspect | Derivative | Owning the asset |
|---|---|---|
| What you hold | A contract linked to the asset | The asset itself |
| Capital needed | Often a margin deposit | Full price |
| Time limit | Often an expiry date | None |
| Going short | Usually easy | Needs borrowing |
What derivatives are used for
Hedging
Producers and investors offset price risk — see Hedging.
Speculation
Traders bet on price moves with less capital.
Shorting
Profiting from falls without borrowing the asset — see Short Selling.
Price discovery
Futures markets help show expected future prices.
Advantages and disadvantages
Advantages
- Allow hedging of existing positions.
- Need less capital than buying the asset outright.
- Make going short straightforward.
- Many trade on regulated exchanges with central clearing.
Disadvantages
- Leverage magnifies losses.
- Expiry and rolling add complexity and cost.
- Some contracts can lose more than the initial deposit.
- Over-the-counter contracts carry Counterparty Risk.
Going deeper
Read as far as you need. Each level builds on the one before it.
Value comes from elsewhere
Beginner
If the underlying moves, the derivative moves too — that is the core idea.1
Rights vs. obligations
Intermediate
Exchange-traded vs. OTC
Advanced
Derivatives can trade on an exchange or off it.2 Exchange contracts are standardised and centrally cleared; over-the-counter contracts can be tailored but depend more on the other party’s ability to pay — see Credit Default Swap.
Common mistakes
Looking at margin, not exposure
Risk is based on the full contract value.
Ignoring expiry
A good idea can fail simply because time ran out.
Selling options without a plan
Short options can carry large or unlimited risk.
Forgetting financing and roll costs
Holding costs reduce net results.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- A derivative is a contract whose value comes from an underlying asset.
- Futures, options, swaps and CFDs are common types.
- Most derivatives involve leverage.
- Futures create obligations; bought options create rights.
- Measure risk on full exposure, not on margin.
Frequently asked questions
Are derivatives only for professionals?
Can I lose more than I put in?
Is a CFD a derivative?
Further learning
- Futures Contract
The standard exchange-traded derivative.
- Options
Rights without obligations for the buyer.
- Leverage
Why derivatives magnify gains and losses.
- Hedging
The original purpose of many derivatives.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- SEC (Investor.gov). Derivatives — glossary (opens in a new tab) Checked .
- CFTC. CFTC Glossary (opens in a new tab) Checked .
- FINRA. Options (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.