A derivative contract is a contract that derives its value from some underlying financial instrument without giving the contract buyer physical ownership of the instrument in question. Derivatives are used by investors to hedge other investments made and to speculate on the price movement of the underlying instruments. The underlying instruments that may be used in a derivative contract can run from simple stocks to market indexes to foreign currencies. Options and futures are two popular types of derivatives, which may be traded over the counter between investors or via a centralized exchange that monitors the trade.
The most common type of investment available to the average investor is stock investing, in which an investor buys shares of stock in a company and hopes that the stock will rise in value. This type of investing can be costly and generally requires a lengthy time commitment by the investor to see a profit. A derivative contract, which can be used by a huge bank or an average investor, allows for flexibility and quick profits in a relatively short period of time.
When an investor enters into a derivative contract, he is usually buying the opportunity to get involved with some sort of underlying financial instrument. In many cases, the actual contract is never actually exercised by the person who holds it. The contracts themselves have value depending on the price performance of the underlying instruments, and they are often bought and sold by investors before their durations are complete.
Options and futures are the most common examples of a derivative contract available to a regular investor. Both base their values on the future price of the underlying financial security. Futures contracts stipulate that the buyer must purchase the underlying security at some date in the future at the current market price. On the other hand, options buyers have the right to buy or sell the underlying securities, but they are not obligated to do so.
With options and futures, investors are trying to guess at the price movement of the underlying instrument, and they're also speculating on the timing of that price movement. Other investors may view derivatives as a means of hedging other investments. An investor using a hedging strategy is essentially buying or selling a derivative contract as a means of balancing out another investment in his portfolio. Hedging is a good way to minimize risk in investments; if done properly, it can also gain profits.