Options & derivatives
Derivative
A contract whose value comes from the price of something else.
How it works
Options, futures, forwards and swaps are all derivatives. None of them require owning the underlying asset; they are agreements about it.
They exist for two legitimate purposes: transferring a risk to someone better placed to carry it, and expressing a view efficiently. They are also the easiest way to take far more risk than intended.
Where it misleads people
The leverage in a derivative is built in rather than borrowed, so it does not look like leverage. A small option premium can control a large exposure, and the loss is not limited to the premium in every strategy.
Related terms
- OptionA contract giving the right, but not the obligation, to buy or sell something at a set price by a set date.
- Futures contractA standardised, exchange-traded agreement to buy or sell something at a set price on a future date.
- SwapAn agreement between two parties to exchange one set of cash flows for another.
- LeverageUsing borrowed money to increase exposure beyond what your own capital would buy.
- Counterparty riskThe risk that the other side of a contract fails to do what it promised.
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Educational reference only. Nothing here is investment advice or a recommendation to buy or sell anything, and tax treatment depends on your own circumstances and the country you are in.