Derivatives, explained from scratch
A derivative moves risk from someone who does not want it to someone who does. Everything else is a variation on that.
Understand what a derivative actually is, and why they exist at all.
How Derivatives works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
Why the debt is the engine
Put in 30, borrow 70, secure the loan against the company you are buying. A 30% rise in the business doubles your money. The same arithmetic works in reverse, which is why buyouts fail loudly.
- 1
You are not trading the thing. You are trading a contract about the thing
A derivative's value is derived from an underlying: a share, a barrel of oil, an interest rate, a currency. You never have to touch the underlying. You are agreeing with someone else about what will happen to it.
- 2
They exist to move risk, and that is genuinely useful
A farmer who fixes the price of next year's wheat can plan. An airline that fixes the price of next year's fuel cannot be destroyed by a spike. In both cases someone else has agreed to carry that risk, for a price. This is insurance, and it is the honest purpose of the entire market.
- 3
There are four families, and they are simpler than they sound
A forward or a future is an obligation to trade at a set price on a set date. An option is the right, but not the obligation, to do so. A swap exchanges one stream of payments for another, most commonly a floating interest rate for a fixed one. Everything exotic is a combination of these.
- 4
Almost all of them embed leverage, which is where the danger lives
You can control a large position for a small outlay. That is the appeal, and it is also why derivatives turn a modest wrong opinion into a total loss. The instrument did not do that. The leverage inside it did.
The most common mistake is speculating while believing you are hedging. If the position makes money when nothing bad happens, it is a bet, not a hedge.
You can explain the difference between a future and an option without looking it up.
Read next
A derivative moves risk from someone who does not want it to someone who does. Everything else is a variation on that.
Every one shows its exact method, and the circumstances in which it is wrong. Free, and no account to look.