What is a derivative? – Definition and example


Derivative, a contract involving two or more parties, represents an agreement based on a financial asset with an underlying security. Functioning as contracts, they contribute to making financial and other transactions more secure, serving as a convenient means to generate essential profits for businesses. Consequently, derivatives become a crucial aspect of trading and various other financial activities.

When dealing with derivatives, parties pre-agree on the financial asset, which is derived from another financial asset. In essence, the contract is contingent on the performance of another asset and is linked to an underlying asset. These characteristics classify derivatives as advanced investment instruments.

Derivative in a nutshell

  • Contracts for financial assets with underlying securities. Enhance security in financial transactions and boost profits.
  • The major type of derivative is the Futures Contract, where parties agree to trade financial assets at a specific price on a particular day.
  • Types of Derivatives: Equity Options, Swaps, Forwards, Interest Rate, Currencies, Commodities, Binary Options.

Distinguishing Futures and Options in Derivatives

We can classify Derivatives into two kinds; Lock and Option.

A lock is a derivative that goes by the name futures and binds the parties on the agreed terms. Now, such terms shall be valid until the contract ends its life.

In contrast, the Option offers a different approach. In the Options derivative, the obligation is not present. The owner holds the right to trade assets before expiration. However, that does not signify there is a guarantee towards ownership of such assets. When someone owns a derivative, it does not mean asset ownership.

The main use of derivatives is to access specific markets and involve trades of different assets. Traders can utilize Derivatives to hedge a position or emulate the asset movement. Since we know there can be unprecedented changes in the trading market, Derivatives can help tackle them. Therefore, by using derivatives, higher profit-earning potential manifolds. 

What is the major type of derivative?

Derivatives can be of various forms. However, the major one is the Futures Contract.

A futures contract is an agreement where parties agree to trade financial assets at a specific price on a particular day. It is standardized by specific prices and rates. Even if the market value increases or decreases, the commodity’s price in the contract will not change; hence, the profit can go to one of the parties, or there won’t be any profit.

For example, Party A decides to buy a stock from Party B next week for $10. When the day comes, the market rate has increased to $20. But B cannot claim that price because the contract has already been accepted by them: Therefore, Party A gets a profit. If the market rate has decreased, then the profit goes to the seller. 

Benefits of derivatives

  • The transaction cost is less compared to other such financial transactions. 
  • It works well under risky situations because it guarantees a price that will be given even if the price is less in the market. 
  • One can transfer the risk to other parties. Therefore, it is comparatively risk-free.

Types of derivatives

The following are a few other types of Derivatives a trader can come across:

Equity option

As a derivative, the Equity Option can also be of two types; calls or puts. Through a call option, the trader gets the right to acquire stock at a fixed price on that particular date. On the contrary, the put option relates to the right to sell an asset on any particular day at a certain price. 

Swap

It is a preplanned formula to exchange cash between two parties at a future date. OTC contracts are the perfect example of swap agreements.

Forwards

These contracts are the same as future contracts. However, these contracts do not have organized deals and are dependent on future circumstances.

Interest Rate

Interest rate derivatives are contracts whose value is determined by the movement of interest rates. These derivatives help market participants manage and hedge interest rate risk. Examples include interest rate swaps, where two parties exchange interest rate obligations, and interest rate options, which give the holder the right to buy or sell interest rate contracts at a specified price.

Commodity

Commodity derivatives derive their value from the price movements of underlying commodities such as gold, oil, agricultural products, etc. Futures and options contracts on commodities are common examples.

Currency

Currency derivatives are financial instruments tied to the foreign exchange market. They include currency futures, options, and swaps. Traders use these derivatives to hedge against currency risk or speculate on currency movements.

Are Binary Options a type of Derivatives?

Yes, Binary Options is a simple derivative with only two outcomes: You can win or you can lose. Binary options derive their value from an underlying asset, such as stocks, commodities, currencies, or market indices.

Invest into rising or falling markets by binary options trading. If you are right in a certain expiration time and the price is higher or lower than your strike price, you will win a high return of up to 90%+. If you are wrong in a certain expiration time, you will lose the investment amount.

About the author

Percival Knight
Percival Knight is an experienced Binary Options trader for more than ten years. Mainly, he trades 60-second trades at a very high hit rate. My favorite strategies is by using candlesticks and fake-breakouts

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