Derivative definition

What are derivatives?

Derivatives are financial products that derive their value from the price of an underlying asset. Derivatives are often used by traders as a device to speculate on the future price movements of an asset, whether that be up or down, without having to buy the asset itself.

As no physical assets are being traded when derivative positions are opened, they normally exist as a contract between two parties, which can be traded over-the-counter or on a stock exchange. A large range of underlying assets can be traded using derivatives, including forex, shares, indices, bonds and commodities.

Examples of derivatives

There is a wide range of derivative products that you can choose from. A popular derivative product is contracts for difference (CFDs).

When you trade CFDs, you are entering into a contract to exchange the difference in the price of an asset from the time your position is opened to when it is closed. Being a derivative, you never take ownership of any assets when trading CFDs, instead you are speculating on the underlying price.

Other examples of derivatives include options, forward contracts and futures contract.

Pros and cons of derivatives

Pros of derivatives

Trading derivatives can be used to hedge: a method of minimising losses to other positions. This is because derivative products offer a larger amount of flexibility when compared to trading the underlying asset directly.

With traditional investing, you open a long position – buying an asset in the hope that it rises in value. But with derivatives, you can also speculate on markets that are falling in price – this is done by opening a short position.

Some derivative products are traded on margin, which means that you only need to put down a fraction of the value of a position to receive full market exposure. Any profit to the position is calculated using the full value of the trade, which can mean that returns on successful trades are magnified. However, it can also amplify your losses. This makes it important to consider your trade in terms of its full value and downside potential.

Cons of derivatives

Derivatives are sometimes criticised for adding to market volatility. In the past, speculators have been accused of greed during times of increasing fuel and food prices, and for causing drastic swings in the markets. Price movements fuelled by speculation can lead to speculative bubbles, which push the intrinsic value of an asset above its normal market price.

When speculative bubbles burst, the effects are often devastating on the markets and even on the economies of countries around the world. This happened in 2008 when the American housing bubble burst.