Derivatives in trading | Learn what they are, types and uses

 

Most beginner traders and investors, come across the term “derivatives” quite early in their journey. When it comes up, the complexity and variations of derivatives might misrepresent what they can actually achieve and in what context. Some see derivatives as an opportunity, others not so much.

 

But there’s nothing scary about derivatives. If anything, they are trading and investing products designed to mitigate risk, if used in the proper context. And even when not used in the context of risk management and the choice is to use them to speculate, trading platforms have the necessary features to surround positions with as much risk mitigation as required by the trader.

 

Derivatives simply put, are financial tools that help people manage risk, protect their money, or try to make a profit.

 

What are derivatives?

Derivatives are financial instruments whose value is derived (taken from) from something else. In the trading and investing jargon, that “something else” is called the underlying asset.

 

Imagine you and your friend making a bet about whether it will snow tomorrow. The value of your bet depends on the weather (the underlying asset). If it snows, one person wins. If it doesn’t, the other person wins. Your bet’s value comes from (and is fully dependent on) the weather.

 

That’s similar to how derivatives work in the financial markets. The underlying asset is a financial market and can be:

 

Important: Derivatives themselves do not have value on their own. The value depends entirely on the price of the underlying asset.

 

Why do derivatives exist?

Derivatives are mainly used for two big reasons and we’ll dig deeper into each of them.

  • To manage risk (called hedging)
  • To try to make a profit (called speculation)

 

Managing risk (hedging)

Imagine you are a farmer growing commodities like corn, barley, wheat, coffee or other. You know that in six months, you will harvest your commodity and immediately sell it. But what if commodity prices drop before then? You could lose a good amount of money.

To protect yourself, you could make an agreement with a willing buyer today, to sell your commodity at a fixed price in the future. As we’ll see later, a futures contract creates an obligation to buy and sell for the parties who enter the contract. So even if commodity prices fall, you are protected.

This contract, the futures contract, is a type of derivative. In itself is meaningless, but with the price of its underlying (the commodity), it’s a valuable active product.

Simply put, derivatives can act like insurance against price changes.

 

Speculation (trying to make a profit)

In the case of commodities, most trading in the futures market, has no intention of owning the underlying. Rather, the goal is to ride the waves of supply and demand created by those with intention to settle, and profit by guessing where the prices will go next.

Same goes with other asset classes as well. With equities for instance, a trader might not want to own shares, but rather ride the waves of their price. If someone thinks shares of Tesla, Inc. will go up next month, they can buy a derivative that increases in value if Tesla’s stock price rises.

If they are right, they can profit the difference from the initial purchase price, minus the closing price and any broker commissions/expenses. If they are wrong, they can lose money *all trading products are risky and carry a possibility of a loss.

 

Common types of derivatives

There are four main types of derivatives, any trader/investor should know about:

  • Futures (like the example above)
  • Forwards
  • Options
  • Swaps

 

We’ll explore each one in simple terms below.

 

Derivatives: Futures

Futures contracts are agreements to buy or sell something at a specific price on a specific future date.

Imagine that today oil costs $70 per barrel. You believe that in three months, oil will cost $80 for fundamental reasons like OPEC’s decision on daily barrel output. You can sign a futures contract to buy oil at $70 in three months.

  • If oil goes up to $80, you profit the difference (minus expenses).
  • If oil drops to $60, you lose your investment.

 

Futures are standardized contracts and they are usually traded on exchanges. This makes them organized and regulated.

Last but not least, it’s important to note that entering a futures contract creates an obligation for settlement. A buyer is obliged to buy at expiry, and a seller is obliged to sell, irrespective of profits or losses.

 

Derivatives: Forwards

A forward contract is very similar to a futures contract. It is also an agreement to buy or sell something at a future date for a set price.

The main differences?

  • Forwards are private agreements between two parties. Therefore, credit or default risk is high, with no intermediation for honouring the contract.
  • They are not traded on public exchanges, therefore they not organized or regulated.
  • They can be customized, since they are not standardized according to the rules of an exchange.

For example, a bakery and a wheat farmer might agree today on a price for wheat to be delivered in six months. This protects both sides from price changes as long as they honour their contract. Legal battles can, and do take place, but the process is costly and time consuming.

 

Derivatives: Options

Options contracts give traders the right, but not the obligation, to buy or sell something at a specific price before a certain date.

That phrase “not the obligation” is very important because it negates the obligation that a futures contract creates.

There are two main types of options:

  • Call option. Gives the owner the right to buy
  • Put option. Gives the owner the right to sell

 

Let’s say shares of Microsoft Corporation are trading at $300. You believe the price will go up. You buy a call option that allows you to buy the stock at $300 within the next month.

  • If the price rises to $350, you can buy at $300 and benefit by selling immediately at 350.
  • If the price falls to $250, you don’t have to buy since you are not obliged to. You can simply let the option expire.

There are 4 ways to actually utilize the full benefit of options contracts, by buying or selling a call, and by buying or selling a put.

Options contracts are often used as protection. For example, an investor who owns stock might buy a put option to protect against a big drop in price.

 

Derivatives: Swaps

A swap is an agreement between two parties to exchange financial payments. A usual swap agreement takes place to swap payments on interest loans. So the most common type is an interest rate swap.

Here’s an example:

  • Company A has a loan with a fixed interest rate.
  • Company B has a loan with a variable interest rate.

If Company A thinks variable rates will go down, and Company B prefers stable payments, they can swap interest payments.

They are not exchanging the loans themselves (the principal). Only the interest payments.

Swaps are typically used by large companies and banks and require a good relationship and trust between the exchanging parties to enter in such contracts.

 

Derivatives: example

Let’s look at a simple example involving airlines.

Airlines use a lot of fuel, right? Fuel prices can go up and down quickly. If fuel prices suddenly rise, airlines can lose a lot of money, given the fuel amounts they go through.

So an airline might use a futures contract to lock in today’s fuel price for future use.

If fuel prices rise later, the airline is protected.
If prices fall, they might miss out on lower prices. But in their view, they gain stability and certainty at a price they are comfortable paying now and into the future.

 

Why are derivatives important?

By definition alone, we can see how derivatives can play a big role within the bigger context of the financial markets. Some important characteristics include (but are not limited to):

 

Risk management

They help companies, farmers, investors, and banks reduce risk. By hedging, everyone is locked in a price they currently feel comfortable with, irrespective of the final outcome of the price.

Price discovery

Due to the sheer volume of traded derivatives, they create the market by showing future expectations about where the price may land. Looking at derivative prices, and comparing them to spot prices, we can hear the markets speaking and we can react accordingly. Think terms like backwardation (when futures price is lower than spot) and a more normalized relationship called contango (when futures price is higher than spot).

Liquidity

Where would the markets be without the liquidity of derivatives? The easy access of buying and selling assets, is heavily dependent on derivatives that make markets anywhere they go.

Flexibility

They allow investors to create strategies that fit their needs, whether they want protection or profit. The risk Vs reward, the ease of access, the velocity by which they move, they all allow for various risk appetites and flexibility with choosing strategies.

 

Are derivatives dangerous?

Absolutely they are. Derivatives are complex financial products and require careful consideration. Since it is a fact that nobody can predict with 100% accuracy what the markets will do next, its important to avoid empty promises of profits, or guaranteed predictions and prophesies.

At the same time, we must recognize that derivatives are tools. Like any tool, they can be used wisely or irresponsibly by traders. For those who use derivatives carefully to reduce risk, they can be very helpful. For speculators, depending on their level of knowledge, they can also prove very cost effective and easy to manage.

For those though, who use them to make risky bets without understanding them, they can lose a lot of money.

During the 2008 financial crisis, complex derivatives connected to housing loans (subprime mortgages) caused serious problems in the global economy. This showed how powerful and risky derivatives can be if not managed properly (both from the buy side as well as the sell side).

 

*this article is provided for educational purposes only. It is not to be construed as investment advice and all visitors are encouraged to keep learning while understanding that trading is exciting but also carries unlimited risk. Lets all be responsible investors to make the most out of the experience.

 

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20
Nov 2025
Trading & Investing