Derivative Meaning: 4 Main Types of Derivatives in Trading

In a mathematical sense, a derivative is the instantaneous rate of change of a function—in other words, the change between a dependent and independent variable. Graphically, mathematicians depict this via the slope of the tangent line. The derivative of a function fluctuates in terms of different inputs and outputs involving numerators, denominators, differential coefficients, secant lines, and other factors.

In most other senses, derivatives also have to do with change from one state to another. For instance, in linguistics, the derivation of a word entails how you change the base of a word (e.g., “function” becoming “functional”). In the world of finance, derivatives are a product also reliant on the nature of constant change, albeit in market indexes and other exchanges.

In finance, derivative contracts are financial products investors can use to hedge their wealth from fluctuations innate to the market. They do so by allowing financially inclined individuals to bet on these changes ahead of time, locking in prices in the present day for their future benefit. These financial instruments also hinge around the slope of a line—the increase or decrease of a commodity’s price.

Some people trade these products on an official exchange—like the CME Group or Chicago Marketing Exchange—whereas others prefer to execute their trades over the counter (or between two like-minded parties). The latter generally carries more risk.

Derivatives come in various different forms. Here are four common types of derivative products:

1. 1. Futures: This first derivative product trades with commodity futures in mind, as the name would suggest. Futures contracts allow investors to lock in the price for an asset now, while still setting their actual date of purchase in the days or months ahead. This way, if the value of the underlying asset increases, they can still purchase it at a lower price. Of course, the opposite can happen, too—the price might fall but they will still have to buy the asset at the higher price they agreed on with the seller.
2. 2. Forwards: This second derivative instrument is, for all intents and purposes, the same as a futures contract but with a much higher degree of credit risk. This is due to the fact that forward contracts do not trade on exchanges. Instead, they trade exclusively over the counter (OTC) between buyers and sellers.
3. 3. Options: Common throughout many financial markets, certain variations of stock options have taken on the names of their home regions (e.g., American options and European options). A put option gives you the right to sell at a predetermined price, whereas a call option allows you to buy under the same guidelines. Unlike with futures contracts, an options trader can decide to pull out of the contract before the expiration date.
4. 4. Swaps: This financial instrument enables people to trade the stipulations attached to their cash flows and other assets. For instance, in interest rate swaps, one company can take on the rate another company paid on a loan and vice versa. Credit default swaps were instrumental to the 2008 financial crisis, leading to regulatory bodies like the Securities and Exchange Commission becoming more strict in the policing of this form of derivatives trading.

Derivatives trading enables you to explore new investment opportunities. Consider these potential benefits of trading in derivatives markets:

• Greater trading potential: If you only trade in traditional assets, you lose out on the ability to profit from more sophisticated forms of investment like derivatives trading. You’ll have access to a greater degree of capital markets and clearinghouses that specialize in this type of trading if you become open to engaging in it yourself.
• Insurance against price movements: Perhaps the most tangible benefit of derivatives is their ability to lock in a fixed rate for commodity prices. In an ever shifting market, this can allow a strategic investor to protect their wealth from unnecessary losses.
• Potential increased rewards: Derivatives might have a higher degree of risk associated with them, but with this comes a greater potentiality of reward. Of course, it remains essential to pair any speculation like this with an adequate risk management strategy.

Derivatives can open you up to a great deal of risk. Here are a few of the cons to engaging in derivatives trading:

• Complex language: These financial contracts can be difficult for laypeople to grasp. If you have a hard time understanding any given points about derivatives trading, clarify them with a professional before diving into the process.
• High volatility: Derivatives open you up to a significant amount of volatility. This is why many financial advisors insist on only utilizing a partial derivative investment strategy.
• Increased possibility of default: There are fewer benchmarks and regulations to preserve liquidity and value in the event of a default for OTC derivatives. This opens up both buyers and sellers to much higher counterparty risk.

It can be difficult to understand even the basic definition of the derivative concept in finance. These examples might help you get a better grasp on it:

1. 1. Crypto hedging: Suppose you expect a certain type of cryptocurrency to undergo a massive spike in prices in the near future. You could reach out to a relevant financial institution to use a futures contract to buy it at a lower price now so you can profit on the increase in value later.
2. 2. Exchange rate insurance: Certain types of assets lose value after you execute a currency swap. For example, suppose you bought an asset in dollars only for euros to become more valuable after the fact. Exchange-traded derivatives allow you to mitigate this risk.
3. 3. Stock options: Imagine your computations indicate a likely decrease in certain shares you own. You could execute a stock option trade to sell at the current price, allowing you to hedge against future losses.

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