A derivative takes its value from something else - a stock, an index, a commodity. The two most common exchange-traded forms are futures and options.
Futures
A futures contract is an agreement to buy or sell an underlying at a set price on a future date. Both parties are obliged to settle. You post a margin rather than the full contract value, which is what creates leverage.
Options
An option gives its buyer the right, but not the obligation, to buy (a call) or sell (a put) at a set strike price before expiry. The buyer pays a premium, which is the most they can lose. The seller receives the premium and takes on the obligation - and a potentially much larger loss.
Why leverage cuts both ways
Because you post only a margin, a small adverse move in the underlying can wipe out a large share of the amount placed. If margins fall short, positions may be squared off without further reference to you. Losses are not limited to the margin deposited.
Legitimate uses
- Hedging an existing holding against a fall.
- Managing exposure around a known event.
- Expressing a view with a defined maximum loss, as an option buyer.
Educational content. This article explains general concepts. It is not investment advice, does not recommend any security or scheme, and takes no account of your personal circumstances. Investments in securities are subject to market risks.