What Does Derivative Mean In Trading?

What Does Derivative Mean In Trading?

The global financial markets are incredibly diverse. Traders can buy and sell shares in companies, currencies, commodities, etc. 

All of these assets physically exist and owning them often comes with advantages and disadvantages. However, some traders simply wish to speculate on the price movements of these instruments without the obligation to own them

For this reason, many traders buy and sell derivative instruments. 

In trading, a derivative is a financial instrument whose value is derived from the value of an underlying asset.

Derivatives are contracts or securities that derive their price and characteristics from an underlying asset, such as stocks, bonds, commodities, currencies, or market indices.

Derivatives hold an important role in the global financial market, providing liquidity and serving as indicators for traders and investors worldwide. 

If you are a beginner trader and would like to know more about what derivatives are and how they work, this Investfox guide is for you. 

Types Of Derivatives

The derivatives market is home to a wide variety of financial instruments. For example, derivatives of the S&P 500 are popular among individual and institutional traders. 

Understanding the different types of derivatives can help you better understand which ones to use during specific market conditions.

Options Contracts

Options provide the holder with the right (but not the obligation) to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) within a specified time frame (expiration date).

Options are used for various strategies, such as protection against price declines (puts) or potential profit from price increases (calls).

Futures Contracts

Futures contracts are standardized agreements to buy or sell an underlying asset at a specified price on a future date.

These contracts are typically traded on organized exchanges. They are commonly used for hedging and speculation.

For example, a mining company may buy futures on precious metals to hedge against price fluctuations. 

Forwards Contracts

Forwards are similar to futures contracts in that they involve agreements to buy or sell an asset at a future date and a specified price.

However, forwards are typically customized and traded over-the-counter (OTC) rather than on organized exchanges.

They are often used for less standardized or more specific transactions, such as customized foreign exchange deals.


Swaps are agreements between two parties to exchange cash flows or assets based on a predefined set of rules.

The most common types include interest rate swaps, where parties exchange fixed and variable interest payments, and currency swaps, where they exchange one currency for another.

Swaps are used for managing interest rate risk, currency risk, and altering cash flow structures.

Contract For Difference (CFD)

A CFD is a contract between a trader and a broker that allows speculation on the price movements of various assets without owning the underlying asset.

CFDs enable traders to profit from both rising and falling markets. They are often used in stock, commodity, and forex trading.

Structured Products

Structured products are financial instruments created by bundling derivatives with other securities, such as bonds or stocks, to create tailored investment products.

They are designed to meet specific investment objectives or risk profiles. For example, a structured product may offer principal protection while providing exposure to the performance of a specific index.

Pros And Cons Of Derivatives Trading

Derivatives trading comes with certain advantages and disadvantages, based on the trading strategy of your choice. 

It is crucial to consider these factors in order to decide whether derivatives trading is the right course of action for your financial objectives.


  • Leverage: Derivatives allow traders to control a larger position with a relatively small upfront investment. This leverage can amplify potential profits when market movements are in your favor
  • Hedging: Derivatives can be used for risk management. Investors and businesses can use derivatives to hedge against adverse price movements in the underlying assets, protecting themselves from potential losses
  • Diversification: Derivatives provide exposure to a wide range of underlying assets, including commodities, currencies, and stock indices. This enables diversification and can reduce the overall risk in a portfolio


  • High Risk: While leverage can magnify profits, it also magnifies losses. Derivatives trading can be highly speculative, and traders can lose more than their initial investment, potentially leading to significant financial losses
  • Complexity: Derivatives often have complex structures and require a good understanding of the underlying assets and the derivative itself. Novice traders may find it challenging to grasp the intricacies of these instruments
  • Counterparty Risk: In some cases, you rely on a counterparty to fulfill the derivative contract. If the counterparty defaults or goes bankrupt, you may face losses

Key Takeaways From What Does Derivative Mean In Trading

  • Derivatives are financial instruments that are used to speculate the price of an underlying asset
  • Types of derivatives include the likes of options, futures, forwards, swaps, and CFDs, as well as structured products that are derivatives of other derivatives
  • Derivatives are traded on major exchanges, such as the Chicago Mercantile Exchange, ro CME
  • Derivatives are risky instruments that are often used to hedge active positions and speculate the market 

FAQ On Derivatives

What are financial derivatives?

Financial derivatives are contracts whose value is derived from an underlying asset, index, or interest rate. They include options, futures, swaps, and forwards. Derivatives are used for hedging, speculation, and risk management in financial markets.

Are derivatives risky?

Yes, derivatives are inherently risky. Their value is linked to underlying assets and can lead to substantial losses. Leverage in derivatives can amplify both profits and losses, making them particularly risky for inexperienced or speculative traders.

What are the types of derivatives?

Types of derivatives include: Futures, forwards, options, CFDs, swaps, and structured products. 

Derivatives may have a wide variety of underlying assets, such as stocks, bonds, indices, cryptocurrencies, currency pairs, etc.