What Are Derivatives? A Guide to Financial Contracts

Derivatives are financial contracts whose value depends on the price or performance of another asset—such as a stock, commodity, interest rate, or foreign exchange rate. Instead of owning the asset itself, investors use derivatives to potentially profit from or protect against changes in the underlying asset's value.

Because their value is linked to something else, derivatives rise or fall as the value of the underlying asset changes. Investors often use derivatives in an attempt to manage risk, speculate on future price movements, or try to generate income. However, derivatives can also magnify losses if financial markets move unexpectedly.

Let's say two investors agree on a contract based on the price of soybeans, with a set expiration date—for example, three months from now. At the time they make the agreement, soybeans are trading at $4 per bushel. If the contract covers 100 bushels, its starting value is $400.

Over the life of the contract, the value will change as soybean prices move. If the price of soybeans later rises to $6 per bushel before the contract expires, the value of that same contract rises to $600. If the price instead falls to $3 per bushel before expiration, the contract's value falls to $300. In other words, the contract's value moves up or down with the price of the underlying asset—in this case, soybeans—until the derivative contract expires.

At that point, an investor generally has a few ways to exit the contract:

• Sell the contract in the open market and pocket the gain or loss.
• Close out the contract by taking an opposite contract. For example, if the original contract benefited when soybean prices rose, the investor could enter a new contract that benefits when prices fall, locking in the gain or loss.
• Hold the contract until it expires, at which point any gain or loss is settled in cash or through delivery, depending on the contract type.

While all derivatives are based on an underlying asset, they can differ in important ways. Some derivative contracts require only a portion of the contract's full value upfront, a feature known as leverage. While leverage can increase potential gains, it can also magnify losses. 

In addition, some derivatives trade on regulated exchanges, while others are negotiated privately over the counter (OTC). Exchange-traded derivatives are typically standardized and benefit from greater liquidity and pricing transparency, while OTC contracts are more customized and can carry higher counterparty risk.

Derivatives come in several main types, each designed to work a little differently. The sections below break down the four most common types—options, futures, swaps, and forwards—and explain how each one works.

Options are one of the most common types of derivatives, and they come in the form of calls and puts. A call option gives the owner the right, but not the obligation, to buy an underlying asset at a predetermined price (known as the strike price) on or before a specific expiration date. A put option gives the owner the right to sell an underlying asset at a predetermined price on or before a specific expiration date. If the call or put is sold, income is received, and the seller is obligated to either sell or buy the underlying asset if assigned on or before the expiration date of the contract. 

Options are commonly described in terms of four basic ways an investor can use them:

• Buying a call: Provides exposure to potential increases in the price of an underlying asset.
• Selling a call: Generates income but obligates the investor to sell the underlying asset, typically a stock or ETF, at a specified price if assigned. This position is often structured as a covered call when the seller already owns the underlying stock.
• Buying a put: Provides exposure to potential declines in the price of an underlying asset.
• Selling a put: Generates income but obligates the investor to purchase the underlying asset at a specified price if assigned.

Keep in mind that options buyers risk losing the full premium paid if the option expires worthless. There is no guarantee there will be enough liquidity to close an options position before expiration. Options sellers, meanwhile, may be assigned at any time.

Futures are standardized, exchange-traded contracts where both parties agree to buy or sell an asset at a set price on a future date. For example, a business or investor might use a futures contract to lock in today's oil price for a purchase or sale that will occur months later, helping reduce uncertainty about future costs. Because futures contracts obligate both parties, the primary risk is that market prices move significantly above or below the agreed-upon level.

Swaps are OTC agreements where two companies agree to exchange future cash flows or liabilities, often tied to interest rates. A common example is an interest rate swap, where one party pays a fixed rate while receiving a variable rate, and the other does the opposite.

For instance, a company seeking predictable payments may prefer a fixed rate, while another expecting rates to decline may favor a variable rate. Each party continues making its own loan payments while exchanging the difference between rates for a set period. These types of swaps are typically used by institutions rather than individual investors.

Forwards are OTC or private agreements between two parties to buy or sell an asset at a future date for a price agreed on today. Like futures, forwards lock in prices, but they are customized agreements rather than standardized exchange-traded contracts. Because they aren't traded on an exchange, there's a higher risk that one party may fail to meet its obligations. As a result, forward contracts are most commonly used by businesses and institutions rather than individual investors. Another key difference between forwards and futures is customization versus standardization. 

Derivatives present risk, but investors often use them for a few primary purposes:

Hedging involves reducing exposure to unwanted price movements. For example, an investor or business may use futures or forwards in an attempt to lock in minimum sale prices, trading lower potential profit for greater certainty and stability.

Some investors use derivatives to take a view on how prices may move in the future. For example, an investor might use options or futures to seek returns if a stock, commodity, or other asset moves as expected (either higher or lower) over a specific time period. While this approach can increase potential returns, it also increases the risk of losses if markets move opposite to the speculator's anticipated direction.

Some investors use derivatives to bring in extra income by selling options and collecting premiums. One common approach is selling call options on stocks they already own (known as covered calls) which provides upfront income but may limit upside if prices rise above the strike price. Because the investor already owns the stock, covered calls are generally considered to have lower risk than other options strategies. Other income‑focused strategies carry higher or different risks.

Derivatives can help manage exposure—how much the investor stands to gain or lose when prices change—but they can also amplify risk. The examples below show how these contracts are used in real-world investing and risk management. Here are a few examples of how derivatives are used in practice.

Investors may purchase broad-based index put options to help hedge their portfolios against a period of heightened uncertainty or market correction. While the strategy involves market timing and comes with a cost, hedging can help investors avoid potential losses during significant market downturns.

Companies with international operations may use derivatives to manage foreign currency risk. By locking in exchange rates, businesses can stabilize future cash flows, though they may miss out on favorable currency movements.

A credit default swap (CDS) is a contract in which an investor pays for protection against the risk that a bond issuer will default. During the 2007–2008 financial crisis, widespread defaults on mortgage-backed securities led to massive CDS payouts that many institutions were unable to cover.

While financial derivatives can be useful tools, they come with risks that are important to understand before using them:

• Leverage risk: Because many derivatives require only a small upfront investment, losses can exceed the initial amount invested if prices move sharply against you.
• Market and timing risk: Derivatives are often tied to specific time frames. If prices don't move as expected before a contract expires, the investment can lose value—even if the long-term view turns out to be correct. Often an investor will need to be right about both the timing and the magnitude of the move in the underlying to achieve a profit.
• Interest rate risk: Changes in interest rates can affect the value of many derivatives, particularly those tied directly to interest rates, such as swaps, futures, and bond-related options. Shifts in rates can also impact the pricing of other derivatives by altering the present value of future cash flows.
• Liquidity risk: Some derivatives may be difficult to buy or sell quickly at a fair price, particularly during periods of market stress. Limited liquidity can make it harder to exit a position when desired or may require accepting a less favorable price.
• Counterparty risk: With OTC derivatives, there's a risk that the other party may not meet its obligations, particularly during periods of market stress. In addition, some derivatives are exposed to the creditworthiness of the underlying issuer (such as bonds), meaning deterioration in credit quality can reduce the value of the contract.
• Operational risk: Because derivatives can be complex, mistakes in trade execution, valuation, margin requirements, or settlement processes can lead to unexpected losses. Managing derivative positions often requires careful monitoring and an understanding of how the contracts work.

The derivatives market offers tools that can help manage risk, potentially enhance returns, or gain exposure to price movements without directly owning the underlying asset, but they involve their own risks and costs. In fact, you might already have some exposure to derivatives through investments like exchange-traded funds (ETFs) or mutual funds, which may use derivatives as part of their strategies.

Derivatives products can help fine-tune your portfolio, but they can also introduce complexity and sharper ups and downs. Before engaging more directly in the derivatives market, consider your investment goals, risk tolerance, and how actively you want to manage positions. A clear understanding of how these contracts work is essential to deciding whether they fit into your broader strategy. 

This discussion is only an introduction to derivatives, and understanding their risks and complexity is key to determining whether they belong in your portfolio.