A derivative is a financial instrument where the value of one instrument is derived from the value of another (the underlier).
The phrase is most commonly used when referring to Futures and Options but stepping aback a little to keep the explanation as straight forward as possible; it’s worth noting that CFDs (Contracts for Difference) are also a derivative. With CFD trading being so popular it’s actually the case that derivative trading is happening on a global scale and some traders might even by slightly surprised to know they are already doing it.
Should your trading strategy suggest taking a long positing in Rio Tinto Plc, for example, you can of course buy the ordinary equity and hold the related share certificate. If you instead buy the CFD instrument relating to Rio Tinto then you’ll enter into a contract with your broker platform. The broker will monitor the change in value of the underlier (that is trading on the London stock exchange) and will post to your account the profit or loss as determined by your entry and exit trades. You won’t hold the underlier itself, but will be exposed to the P&L from its price movements.
Because you are trading a ‘synthetic’ instrument the broker platform can offer you terms and conditions that might be attractive to you. You might for example look to benefit from being able to leverage the position or from certain tax advantages associated with CFDs.
Futures and Options work in a similar way. If you buy or sell, a Future or Option on the DAX Index, the value of the asset you are holding will be a function of the price changes in the underlier, the DAX itself. The two instruments have certain characteristics that CFDs don’t. It’s the additional features that mean Futures and Options are considered something for the more advanced trader and why they tend to be what traders have in mind when discussing “derivatives”.
The popularity of Futures and Options stems from some of these more complex aspects of their structure giving traders scope to trade more advanced strategies. Whilst Futures and Options have a very valid reputation for being risky, a large number of institutional grade traders actually use them to manage risk. Whether you are looking to trade Futures and Options in their own right, or to hedge risk on the rest of your portfolio, you will need to ensure you have a firm understanding of how they work before trading them. Not all platforms offer Futures and Options markets, so you probably want to look at the bigger players like Plus500 who even support trading of them in their Demo account.
The term ‘derivatives’ covers a wide range of instruments including: CFDs, Options and Futures. The common feature being that their value is derived from another instrument; in trading circles, the term usually refers to Futures and Options.