# Understanding Derivatives: A Comprehensive Guide to Their Uses and Benefits

What you need to know about these securitized contracts

![Photo and illustration composite of two people shaking hands, indicating a trading deal has been confirmed.](https://www.investopedia.com/thmb/8R5G4xgHVfVhi_VNkHiMgOb5lI8=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/DerivativesTypesConsiderationsandProsandCons_final-104fe13cf7794cefa5332690df022308.png)

*There are several different kinds of derivatives, including futures, forwards, swaps, and options. — Investopedia / Michela Buttignol*

> **Definition**
>
> A derivative is a kind of financial contract between two or more parties, the value of which fluctuates based on the price of one or more underlying assets. Traders can purchase these agreements and utilize them to hedge against risk, speculate on the asset's movement, or leverage a position.

## What Is a Derivative?

The term “derivative” refers to a type of financial contract whose value is dependent on an [underlying asset](https://www.investopedia.com/terms/u/underlying-asset.asp), a group of assets, or a benchmark. Derivatives are agreements set between two or more parties that can be traded on an exchange or [over the counter (OTC)](https://www.investopedia.com/terms/o/otc.asp).

These contracts can be used to trade any number of assets and come with their own risks. [Prices for derivatives](https://www.investopedia.com/ask/answers/060315/how-price-derivative-determined.asp) derive from fluctuations in the prices of underlying assets. These financial securities are commonly used to access certain markets and may be traded to [hedge](https://www.investopedia.com/terms/h/hedge.asp) against risk. Derivatives can be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate reward (speculation). Derivatives can move risk levels (and the accompanying rewards) from the [risk-averse](https://www.investopedia.com/terms/r/riskaverse.asp) to the [risk seekers](https://www.investopedia.com/terms/r/risklover.asp).

### Key Takeaways

*   Derivatives are financial contracts, set between two or more parties, that derive their value from an underlying asset, a group of assets, or a benchmark.
*   A derivative can [trade](https://www.investopedia.com/best-online-brokers-4587872) on an exchange or over the counter (OTC).
*   Prices for derivatives derive from fluctuations in the prices of underlying assets.
*   Derivatives are usually leveraged instruments, which increases their potential risks and rewards.
*   Common derivatives include futures contracts, forwards, options, and swaps.

![Derivative](https://www.investopedia.com/thmb/bezXXAgWXlTFDKDaUNdQh231nkA=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/derivative_final-fbb671f41d73438a96a5b8a8110145f0.png)

*— Investopedia / Katie Kerpel*

## How Derivatives Work

A derivative is a complex financial security that's set between two or more parties. Derivatives can take many forms, from stock and bond derivatives to [economic indicator derivatives](https://www.investopedia.com/terms/e/economic_derivatives.asp).

Traders may use derivatives to access specific [markets](https://www.investopedia.com/terms/m/market.asp) and trade different assets. Typically, derivatives are considered a form of advanced investing. The most common underlying assets for derivatives are stocks, bonds, [commodities](https://www.investopedia.com/terms/c/commodity.asp), [currencies](https://www.investopedia.com/terms/c/currency.asp), [interest rates](https://www.investopedia.com/terms/i/interestrate.asp), and [market indexes](https://www.investopedia.com/terms/m/marketindex.asp). Contract values depend on changes in the prices of the underlying asset—the [primary instrument](https://www.investopedia.com/terms/p/primary-instrument.asp).

Derivatives can be used to hedge, speculate on the directional movement of an underlying asset, or leverage a position. These assets are commonly traded on exchanges or OTC, and can often be entered via an [online broker](https://www.investopedia.com/best-online-brokers-4587872). The [Chicago Mercantile Exchange (CME)](https://www.investopedia.com/terms/c/cme.asp) is among the world’s largest derivatives exchanges.

It’s important to remember that when companies hedge, they’re not speculating on the price of the commodity. Instead, the hedge is an attempt to limit existing risks. Each party has its profit or margin built into the price, and the hedge helps protect those profits from being eliminated by unfavorable market moves in the price of the underlying asset.  

OTC-traded derivatives generally carry a greater [counterparty risk](https://www.investopedia.com/terms/c/counterpartyrisk.asp)—the danger that one of the parties involved in the transaction might not deliver on its obligations, or [default](https://www.investopedia.com/terms/d/default2.asp). OTC contracts are privately negotiated between two counterparties and are unregulated. To hedge this risk, the investor could purchase a currency derivative to, for example, lock in a specific exchange rate. Derivatives that could be used to hedge forex risk include [currency futures](https://www.investopedia.com/terms/c/currencyfuture.asp) and [currency swaps](https://www.investopedia.com/terms/c/currencyswap.asp).

> **Important**
>
> Exchange-traded derivatives, such as options and futures, are standardized and more heavily regulated than those traded OTC and can be freely bought and sold via most online brokers.

## Special Considerations

Derivatives were originally used to ensure balanced exchange rates for internationally traded goods. International traders needed a system to account for the constantly changing values of [national currencies](https://www.investopedia.com/terms/n/national-currency.asp).

Assume a European investor has investment accounts that are all denominated in [euros](https://www.investopedia.com/terms/e/euro_note.asp) (EUR). Let’s say they purchase shares of a United States company through a U.S. exchange using U.S. dollars (USD). This means they're now exposed to [exchange rate risk](https://www.investopedia.com/terms/f/foreignexchangerisk.asp) while holding that stock. Exchange rate risk is the threat that the value of the EUR will increase in relation to the USD. If this happens, any profits the investor realizes upon selling the stock become less valuable when they're converted back into EUR.

A [speculator](https://www.investopedia.com/terms/s/speculator.asp) who expects the euro to appreciate vs. the dollar could profit by using a derivative that rises in value with the euro. When using derivatives to speculate on the price movement of an underlying asset, the investor doesn't need to have the actual underlying asset in their [portfolio](https://www.investopedia.com/terms/p/portfolio.asp).

> **Fast Fact**
>
> Many derivative instruments are leveraged, which means a small amount of capital is required to have a sizable position in the underlying asset.

## Types of Derivatives

Derivatives today are based on a wide variety of underlying assets and have many uses, even unconventional ones. For example, there are derivatives based on weather data, such as the amount of rain or the number of sunny days in a region.

There are [different types of derivatives](https://www.investopedia.com/terms/e/economic_derivatives.asp) that can be used for [risk management](https://www.investopedia.com/terms/r/riskmanagement.asp), [speculation](https://www.investopedia.com/terms/s/speculation.asp), and leveraging a position. The derivatives market continues to grow, expanding with products to fit nearly any need or level of [risk tolerance](https://www.investopedia.com/terms/r/risktolerance.asp).

There are two classes of derivative products: lock and [option](https://www.investopedia.com/ask/answers/070615/what-difference-between-derivatives-and-options.asp). Lock products (e.g., futures, forwards, or swaps) bind the respective parties from the outset to the agreed-upon terms over the life of the contract. Option products (e.g., stock options), on the other hand, offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option’s expiration date. The most common derivative types are futures, forwards, swaps, and options.

### Futures

A [futures contract](https://www.investopedia.com/terms/f/futurescontract.asp), or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date. Futures are standardized contracts that trade on an exchange. Traders use futures to hedge their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset.

For example, say that on Nov. 6, 2025, Company A buys a futures contract for oil at a price of $62.22 per barrel that expires Dec. 19, 2025. The company does this because it needs oil in December and is concerned that the price will rise before the company needs to buy. Buying an oil futures contract hedges the company’s risk because the seller is obligated to deliver oil to Company A for $62.22 per barrel once the contract expires. Assume oil prices rise to $80 per barrel by Dec. 19, 2025. Company A can accept delivery of the oil from the seller of the futures contract, but if it no longer needs the oil, it can also sell the contract before expiration and keep the profits.

In this example, both the futures buyer and seller hedge their risk. Company A needed oil in the future and wanted to offset the risk that the price may rise in December with a long position in an oil futures contract. The seller could be an oil company concerned about falling oil prices that wanted to eliminate that risk by selling or [shorting](https://www.investopedia.com/terms/s/shortselling.asp) a futures contract that fixed the price it would get in December.

It's also possible that one or both of the parties are speculators with the opposite opinions about the price of oil in December. In that case, one might benefit from the contract, and one might not. Take, for example, the futures contract for [West Texas Intermediate (WTI)](https://www.investopedia.com/terms/w/wti.asp) oil that trades on the CME and represents 1,000 barrels of oil. If the price of oil rose from $62.22 to $80 per barrel, the trader with the long position—the buyer—in the futures contract would have profited $17,780 \[($80 - $62.22) × 1,000 = $17,780\]. The trader with the short position—the seller—in the contract would have a loss of $17,780.

### Cash Settlements of Futures

Not all futures contracts are settled at expiration by delivering the underlying asset. If both parties in a futures contract are speculating investors or [traders](https://www.investopedia.com/financial-edge/0312/how-to-become-a-day-trader.aspx), it's unlikely that either of them would want to make arrangements for the delivery of a large number of barrels of crude oil. Speculators can end their obligation to purchase or deliver the underlying commodity by closing (unwinding) their contract before expiration with an offsetting contract.

Many derivatives are, in fact, [cash-settled](https://www.investopedia.com/terms/c/cashsettlement.asp), which means that the gain or loss in the trade is simply an accounting cash flow to the trader’s brokerage account. Futures contracts that are cash-settled include many interest rate futures, [stock index futures](https://www.investopedia.com/terms/i/indexfutures.asp), and more unusual instruments, such as [volatility futures](https://www.investopedia.com/stock-analysis/2012/4-ways-to-trade-the-vix-vxx-vxz-tvix-xxv0504.aspx) or [weather futures](https://www.investopedia.com/terms/w/weatherderivative.asp).  

### Forwards

[Forward contracts](https://www.investopedia.com/terms/f/forwardcontract.asp), or forwards, are similar to futures, but they don't trade on an exchange. These contracts only trade OTC. When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. As OTC products, forward contracts carry a greater degree of counterparty risk.

Counterparty risks are a type of [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp) where the parties involved may fail to deliver on the obligations outlined in the contract. If one party becomes insolvent, the other party may have no recourse and could lose the value of its position.

Once created, the parties in a forward contract can offset their positions with other counterparties, which can increase the potential for counterparty risks as more traders become involved in the same contract.

### Swaps

[Swaps](https://www.investopedia.com/terms/s/swap.asp) are another common type of derivatives, often used to exchange one kind of cash flow for another. For example, a trader might use an [interest rate swap](https://www.investopedia.com/terms/i/interestrateswap.asp) to switch from a variable-rate loan to a fixed-rate one, or vice versa.

Imagine that Company XYZ borrows $1,000,000 and pays a [variable interest rate](https://www.investopedia.com/terms/v/variableinterestrate.asp) on the loan that's currently 6%. XYZ may be concerned about rising interest rates that will increase the costs of this loan or encountering a lender that's reluctant to extend more credit while the company has this variable-rate risk.

Assume XYZ creates a swap with Company QRS, which is willing to exchange the payments owed on the variable-rate loan for the payments owed on a fixed-rate loan of 7%. That means that XYZ will pay 7% to QRS on its $1,000,000 principal, and QRS will pay XYZ 6% interest on the same principal. At the beginning of the swap, XYZ will just pay QRS the one-percentage-point difference between the two [swap rates](https://www.investopedia.com/terms/s/swaprate.asp).

If interest rates fall so that the variable rate on the original loan is now 5%, Company XYZ will have to pay Company QRS the two-percentage-point difference on the loan. If interest rates rise to 8%, then QRS would have to pay XYZ the one-percentage-point difference between the two swap rates. Regardless of how interest rates change, the swap has achieved XYZ’s original objective of turning a variable-rate loan into a [fixed-rate](https://www.investopedia.com/terms/f/fixedinterestrate.asp) one.

Swaps can also be constructed to exchange [currency risk](https://www.investopedia.com/terms/c/currencyrisk.asp) or the risk of default on a loan or cash flows from other business activities. Swaps related to the cash flows and potential defaults of mortgage bonds are an extremely popular derivative. In fact, they’ve been a bit too popular in the past. It was the counterparty risk of swaps like this that eventually spiraled into the [credit crisis](https://www.investopedia.com/terms/c/credit-crisis.asp) of [2008](https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp).

### Options

An [options contract](https://www.investopedia.com/terms/o/optionscontract.asp) is similar to a futures contract in that it's an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that with an option, the buyer isn't obliged to exercise their agreement to buy or sell. It's an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset.

> **Tip**
>
> In terms of timing your right to buy or sell, it depends on the “style” of the option. An American-style option allows holders to exercise their option rights anytime before and including the day of expiration. A European-style option can be executed only on the day of expiration. Most stocks and exchange-traded funds (ETFs) have American-style options, while equity indexes, including the S&P 500, have European-style options.

Imagine an investor owns 100 shares of a stock worth $50 per share. They believe the stock’s value will rise in the future. However, this investor's concerned about potential risks and decides to hedge their position with an option. The investor could buy a put option that gives them the right to sell 100 shares of the underlying stock for $50 per share—known as the [strike price](https://www.investopedia.com/terms/s/strikeprice.asp)—until a specific day in the future—known as the [expiration date](https://www.investopedia.com/terms/e/expirationdate.asp). The option costs $2 per share. Each option contract represents 100 shares, so the investor paid $200 to enter this trade.

Assume the stock falls in value to $40 per share by expiration and the put option buyer decides to exercise their option and sell the stock for the original strike price of $50 per share. As such, the investor only lost $200—the price he paid for the options. An unhedged position would’ve shown a loss of $1,000. A strategy like this is called a [protective put](https://www.investopedia.com/terms/p/protective-put.asp) because it hedges the stock’s downside risk.

Alternatively, assume an investor doesn’t own the stock currently worth $50 per share. They believe its value will rise over the next month. This investor could buy a call option that gives them the right to buy the stock for $50 before or at expiration. Assume this call option costs $2 per share, or $200 for the trade, and the stock rose to $60 before expiration. The buyer can now exercise their option and buy a stock worth $60 per share for the $50 strike price and record a gain of $10 per share. Subtracting $2 per share paid to enter the trade, and any broker fees, the investor is looking at approximately $800 net profit.

In both examples, the sellers are obligated to fulfill their side of the contract if the buyers choose to exercise the contract. However, if a stock’s price is above the strike price at expiration, the [put](https://www.investopedia.com/terms/p/putoption.asp) option will be worthless and the seller ([the option writer](https://www.investopedia.com/terms/w/writing-an-option.asp)) gets to keep the premium at expiration. If the stock’s price is below the strike price at expiration, the [call](https://www.investopedia.com/terms/c/calloption.asp) will be worthless and the call seller will keep the premium.

![What Is a Derivative?](https://www.investopedia.com/thmb/8o-Re9v-5cph7aUGFHOGc0luBcg=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/derivative.finalJPEG-5c8982d646e0fb00010f11c9.jpg)

*— Melissa Ling © Investopedia, 2019*

## Advantages and Disadvantages of Derivatives

### Advantages

As the above examples illustrate, derivatives can be a useful tool for businesses and investors alike. They provide a way to:

*   Lock in prices
*   Hedge against unfavorable movements in rates
*   Mitigate risks

These pluses can often come for a limited cost.

> **Fast Fact**
>
> Derivatives also can often be purchased on margin, which means traders use borrowed funds to purchase them. This makes them even less expensive.

### Disadvantages

Derivatives can be difficult to value because they're based on the price of another asset. OTC derivatives also include [counterparty risks](https://www.investopedia.com/terms/c/currentexposuremethod.asp) that are difficult to predict. Additionally, most derivatives are sensitive to the following:

*   Changes in the amount of time until expiration
*   Any costs associated with holding the underlying asset
*   Interest rates

These variables make it difficult to perfectly match the value of a derivative with the underlying asset.

Because the derivative has no intrinsic value—its value comes only from the underlying asset—it's vulnerable to [market sentiment](https://www.investopedia.com/terms/m/marketsentiment.asp) and market risks. [Supply and demand](https://www.investopedia.com/terms/l/law-of-supply-demand.asp) factors can cause a derivative’s price and its [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) to rise and fall, regardless of what's happening with the price of the underlying asset.

Finally, derivatives are usually leveraged instruments, and using leverage cuts both ways. While it can increase potential returns, it also makes losses mount quicker.

Pros

*   Lock in prices
    
*   Hedge against risk
    
*   Can be leveraged
    
*   Portfolio diversification
    

Cons

*   Hard to value
    
*   Subject to counterparty risks (if OTC)
    
*   Complex to understand
    
*   Sensitive to supply and demand factors
    

> **Tip**
>
> Want to learn more advanced investing and trading strategies? Check out our guide—Level Up Your Investing Strategy—to elevate your approach and maximize returns.

## What Are Derivatives?

Derivatives are securities whose value is dependent on or derived from an underlying asset. For example, an [oil futures contract](https://www.investopedia.com/articles/active-trading/040615/introduction-trading-oil-futures.asp) is a type of derivative whose value is based on the market price of oil. Derivatives have become increasingly popular in recent decades, with the [total value of derivatives outstanding](https://www.investopedia.com/ask/answers/052715/how-big-derivatives-market.asp) estimated at $729.8 trillion on June 30, 2024.

## What Are Some Examples of Derivatives?

Common examples of derivatives include futures contracts, options contracts, and [credit default swaps](https://www.investopedia.com/terms/c/creditdefaultswap.asp). Beyond these, there's a vast quantity of derivative contracts tailored to meet the needs of a diverse range of counterparties. In fact, because many derivatives are traded over the counter (OTC), they can in principle be infinitely customized.

## What Are the Main Benefits and Risks of Derivatives?

Derivatives can be a very convenient way to achieve financial goals. For example, a company that wants to hedge against its exposure to commodities can do so by buying or selling energy derivatives, such as crude oil futures. Similarly, a company could hedge its currency risk by purchasing currency-forward contracts. Derivatives can also help investors leverage their positions, such as by buying equities through stock options rather than shares.

The main drawbacks of derivatives include counterparty risk, the inherent risks of leverage, and the fact that complicated webs of derivative contracts can lead to [systemic risks](https://www.investopedia.com/terms/s/systemic-risk.asp).

## The Bottom Line

A derivative is a type of financial contract that can be traded as an investment. Derivatives have no intrinsic value. Their worth comes entirely from the value of the underlying asset.

Derivatives can be used to mitigate risk or to assume risk in the hope of achieving a reward. Regardless of your goal as an investor, derivatives come with potential downsides, including complexity, supply and demand factors, and vulnerability to market sentiment.

> **Article Sources**
>
> 1.  CME Group. “[About CME Group](https://www.cmegroup.com/company/).”
>     
> 2.  CME Group. “[Crude Oil](https://www.cmegroup.com/markets/energy/crude-oil/light-sweet-crude.html).”
>     
> 3.  Bank for International Settlements. “[OTC Derivatives Statistics at End-June 2024](https://www.bis.org/publ/otc_hy2411.htm).”