Source: Tavaga

A derivative is a financial instrument in the form of a contract between a buyer and seller, with its value derived from the value of an underlying asset or a group of assets (index), and agreed upon by both parties. They are traded on an exchange and are more liquid than their underlying asset(s).

A derivative contract can be an obligation or a right to let one of the parties to buy or sell (depending upon the kind of derivative) the underlying asset(s) by a certain date if the contract-assigned price of the underlying asset(s) is lucrative for the contract holder. 


Popular derivatives include options and futures

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Certain derivatives like options are used for speculative gains (as there is no obligation) and derivatives like futures are used for hedging gains.

The party buying the derivatives contract is said to be holding the long position while the party selling the derivatives contract is said to be holding the short position.Often derivatives traders, such as retail investors and hedge funds in the case of commodity trading, trade the contract itself rather than deal in (or take delivery of) the underlying asset as the physical assets are of no use to them. This is done before the contract expiry as in any volatile market price movements can always make a derivatives contract, in itself, valuable to hold or sell.

Why do investors use derivatives?

  1. Arbitrage advantage – Buying a good or asset at a discount in one market and selling it at a premium in the other is known as arbitrage trading. You gain from the disparities in the commodity’s price between the two markets in this way.
  2. Protection against market volatility – A change in an asset’s price could make losses more likely. The derivatives market has products that can help you protect yourself from a drop in the value of the stocks you hold. In addition, if you want to purchase stocks, you can purchase items to protect against a price increase.
  3. Park surplus funds – Derivatives are a tool used by some people to transfer risk. Others, however, use it to speculate and profit from it. In this case, you can profit on price changes without actually selling the underlying shares.