What are derivatives and how do they work

By the dictionary definition, a derivative is something that is based on another source, in financial terms it follows that concept - a derivative is a contract that derives its value from the performance of an underlying entity such as an asset, index or interest rate.

What can derivatives be used for?
  • Insuring against price movements (hedging)
  • Increasing exposure to price movements for speculation - a small movement in the value of the underlying asset results in a larger profit
  • Getting access to otherwise hard-to-trade assets or markets.
  • Avoid paying taxes - an equity swap allows an investor to receive steady payments while avoiding paying capital gains tax and keeping the stock

What are the most common types of derivatives?
  • Forwards. Forward contracts are non-standardised contracts between two parties to buy or sell assets at a specified future time with a price that is agreed today, like other derivative securities they can be used to hedge risk. 
  • Futures. A futures contract is a standardised forward contract that can be traded between parties other than the two parties that originally made the contract. They agree to buy and sell an asset for the forward price with payment at the delivery date. These contracts are negotiated at futures exchanges.
  • Options. This type of contract gives the holder of the option the right to buy or sell an underlying asset at a specified strike price on a specified date. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or premium. They can also choose not to buy/sell this asset, but the seller has the obligation to fulfill the transaction if the owner exercises the option.
  • Swaps. In a swap two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. Swaps can be used to hedge risks such as interest rate or to speculate on changes in the expected direction of underlying prices. Swaps are some of the most heavily traded financial contracts in the world.
How can an individual investor take advantage of derivatives?
The general answer is unless you have a substantial net worth and a very qualified investment adviser, stay away from derivatives. Derivatives are a complex form of trading and although they offer advantages such as a relatively small initial investment price compared to buying company stock, they are riskier than traditional investments as at its core a derivative is a piece of paper that represents another investment such as an option based on an investment like oil. The purchaser of the derivative is not buying the actual oil, they are investing in the derivative. 

If you are still interested in this, then you can read my article "how to trade in derivatives", although be sure you read all the information about different types of derivatives and their advantages first. Make sure you understand it all, read some books on the topic and don't gamble with money you can't afford to lose.