Derivatives

Stock trading dictionary: meaning, example and how traders use it.

Last updated: October 17, 2026

Definition: Derivatives are financial contracts whose value is derived from the price of an underlying asset, index, rate or event, such as a stock, bond, commodity or currency. Common types include options, futures, forwards and swaps.

How derivatives work

A derivative is an agreement between two parties tied to an underlying asset. The holder does not need to own the asset itself; the contract's value rises or falls as the underlying price changes. Some derivatives trade on regulated exchanges with standardized terms and central clearing. Others are negotiated privately over the counter, with terms tailored to each party and greater counterparty risk.

Main types of derivatives

  • Options: an option gives the right, not the obligation, to buy (a call) or sell (a put) at a set price.
  • Futures: a futures contract obligates both sides to trade the underlying at a set price on a future date.
  • Forwards: private, customizable versions of futures.
  • Swaps: agreements to exchange cash flows, such as fixed for floating interest payments.

Derivatives example: hedging

Suppose an investor owns 100 shares of a stock trading at $80 and worries about a near-term decline. She buys one put with a $75 strike for $2.00, costing $200. If the stock falls to $60, her shares lose $2,000, but the put is worth at least $15.00, or $1,500, offsetting most of the loss beyond the strike. If the stock rises instead, she keeps the gains minus the $200 cost. The derivative acted like insurance on her portfolio.

How investors use derivatives

Derivatives serve three broad purposes. Hedging reduces risk, as with a farmer selling grain futures or an airline locking in fuel costs. Speculation seeks profit from price moves, often with leverage because only a fraction of the exposure must be paid up front. Arbitrage exploits pricing differences between a derivative and its underlying asset. Derivatives also help market makers manage inventory and provide liquidity.

Exchange-listed derivatives are also used to build income strategies. Writing options against existing holdings, for example, collects premium in exchange for giving up some upside. Institutional investors use index futures to adjust market exposure quickly without trading every stock in a portfolio, and companies use interest-rate swaps to convert floating-rate debt into fixed payments. In each case the derivative shifts a specific risk from one party to another, which is why derivatives markets are sometimes described as markets for risk itself rather than for the underlying assets.

Risks of derivatives

  • Leverage risk: small moves in the underlying can cause large gains or losses.
  • Time decay: options lose value as expiration approaches.
  • Counterparty risk: in over-the-counter contracts, the other side may fail to pay.
  • Complexity: payoffs can be hard to understand, especially for multi-leg strategies.

Brokers require separate approval for options and futures trading because of these risks. See also investment risks.

Frequently asked questions

What are the four main types of derivatives?

The four main types are options, futures, forwards and swaps. Options and futures are widely traded on exchanges, while forwards and most swaps trade over the counter.

Are derivatives risky?

They can be. Leverage, complexity and time decay can produce large losses, but derivatives are also widely used to reduce risk through hedging.

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For information only, not investment advice. See the disclaimer.