A financial derivative is a security that gets its value from another asset. As the price of the asset changes, so does the value and price of the derivative. A derivative is the right or obligation to have something happen in the future. Most often, a derivative gives you the option to buy or sell something in the future.
One type of financial derivative is an option. You have the right to do something in the future if you hold an option. If you own a call option, you are allowed to buy something in the future for the current price. If you own a put option, you have the right to sell something in the future for the price today.
The two main reasons to buy a derivative is to hedge risk or speculate. You hedge risk with a derivative by locking in a price. Let’s say you need to buy a large quantity of gasoline in six months. If gas prices stay at today’s price of $2.80, you’ll be fine. If prices rise, you might not be able to afford what you need. By purchasing a call option, you have the right to buy gasoline at $2.80 per gallon in six months. If the price ends up being $3.00 per gallon, you made a great decision. If the price is $2.75 per gallon, you can decline your option and buy at $2.75 per gallon.
The other main use of derivatives is to speculate. If you think the price of gasoline will increase from today’s price of $2.80 per gallon, you should buy today to sell later. Instead of buying tons of gasoline, you can purchase an option to buy gasoline at $2.80 per gallon in six months. When the actual price is $3 per gallon in the future, you make a profit.
A derivative can get its value from anything that has a fluctuating price. A lot of derivatives cover stocks, bonds, gasoline, agricultural products, and foreign currency exchanges. Just like stocks and bonds, you buy and sell derivatives in various markets.