Derivatives
What Are Derivatives?
Derivatives are financial contracts whose value is based on the price of an underlying asset, like stocks, commodities, currencies, or even interest rates. Rather than buying the asset directly, traders use derivatives to bet on how its price will move, which can offer ways to manage risk or amplify potential profits.
How It Works
- Underlying Asset: A derivative's value is tied to the price movements of something else—like a barrel of oil or the price of Bitcoin. The price of the derivative goes up or down based on changes in that underlying asset.
- Types of Derivatives: Common derivatives include futures (including perpetuals, or perps), options, and swaps. Each type has different structures and purposes, from locking in prices for the future to providing insurance against price swings.
- Risk Management or Speculation: Some use derivatives to protect against price changes (hedging), while others use them to bet on price movements (speculation).
Example
Imagine you're trading on an exchange and expect the price of Bitcoin to drop soon. To profit from this, you enter a short position by selling a futures contract, locking in today’s higher price. If Bitcoin’s price drops as expected, you can close the contract at the lower market price, making a profit on the difference. Here, the futures contract lets you hedge or speculate on price changes without needing to hold the actual asset.
Key Takeaways
- Derivatives are contracts that derive their value from another asset’s price movements.
- They can be used for hedging (risk management) or speculation (profit-seeking).
- Common forms include futures (including perpetuals or perps), options, and swaps, each with unique purposes and structures.
In short, derivatives are financial contracts that allow traders to bet on or protect against price changes of assets without owning them, giving investors flexibility in managing risk and potential profit.