Derivatives
A derivative is a contract whose value depends on another asset, such as a stock index, a currency, an interest rate or a barrel of oil. They are used to hedge risk, and to take on more of it.
The main types
- Futures: an obligation to buy or sell at a set price on a set date.
- Options: the right, but not the obligation, to buy (call) or sell (put) at a set price.
- Swaps: two parties exchange payment streams, such as fixed for floating interest.
Why they matter for everyone
Farmers lock in prices for their harvest, airlines hedge fuel, companies hedge currencies, and banks manage interest-rate risk. Options markets also tell us how much volatility traders expect. The VIX index is built from S&P 500 option prices.
How it can hurt you
Derivatives usually involve leverage: a small amount of money controls a large position. Losses can exceed the money put in, and options can expire worthless. Most retail investors who trade them lose money.
The rhyme
Portfolio insurance and Black Monday, 1987In the mid-1980s many pension funds used "portfolio insurance", a strategy that sold stock index futures automatically as prices fell. On 19 October 1987 that selling fed on itself, and the Dow fell 22.6% in a single day, its largest one-day percentage drop on record. The episode led to circuit breakers that pause trading during extreme falls, rules that still exist today.
Terms you will hear
- Call / put
- An option to buy / an option to sell.
- Strike price
- The price at which an option can be used.
- Margin
- Money posted as security for a leveraged position.
- Hedging
- Taking a position to offset a risk you already have.
- VIX
- An index of expected S&P 500 volatility, often called the fear gauge.
Derivatives are complex and leveraged, and losses can exceed the amount invested. This page is general education, not a recommendation to trade.