Derivatives: introduction: what is a derivative
n broad terms, a derivative is a financial contract entered into between two or more parties, the performance of which is ‘derived’ or based on the future value or price of an underlying asset, which does not have to be bought or sold.
The underlying subject matter of a derivative contract can be any asset or bundle of assets, tangible or intangible, real or notional, provided a value or measurement can be attached to it.
Where the underlying asset, upon which a derivative contract is written, represents equities or securities (commonly, stocks and shares), the main types of derivative contracts that are issued and subsequently traded and/or exercised include:
- Options (see STSM112000);
- Warrants (see STSM114000, STSM115000 and STSM116000);
- Futures & Forwards (see STSM117000); and
- Contracts For Difference (see STSM118000)
Buying and selling derivatives can be attractive as large profits (but also losses) can be made on a small initial monetary outlay or stake money paid. Because derivatives are essentially a bet on which way the price of the underlying security will move, profit can be made irrespective of whether the market value of the underlying asset goes up or down in value. This is not the case with a direct purchase of stocks and shares where profit can only be made if the underlying market share price rises.
At the heart of derivatives is the concept of deferred delivery. A derivative allows a holder, albeit in different ways, to agree today the price at which a holder may, or will, buy or sell an asset sometime in the future.