A derivative can be broadly explained as any product which is derived from something. That is to say that it is not the actual product itself but rather a substitute or reflection of that product.
For example in the case of a CFD (Contract For Difference) this is something which is derived from the underlying share price of a company.
There are many types of derivatives available in the market place but the main two are options and futures.
CALL OPTIONS – An investor can buy a 250p call option in say Vodafone for 10p. This call option gives the holder the right (or ‘option’) to buy Vodafone at the price of 250p. The cost of this is the premium which is 10p. Therefore the investor is expecting the share price to go up.
PUT OPTIONS – A put option is almost the exact opposite of a call option. It gives the holder of the option the right to SELL a particular company share at a specific price. Therefore the investor is expecting the share price to go down.
Options are very dynamic and flexible tools and have a number of benefits over other types of investment products. It also opens the opportunity to implement different strategies.
For a start they can give investors an opportunity to either speculate (increase risk) or hedge (reduce risk). However and as is the case with all margined products, you do need to be careful as you can lose more than the value of your original investment.
A futures contract is another form of derivative and can take various forms including CFDs, spread betting and so on. It is a leveraged product and so the risks are higher but if used correctly and in a measured approach it is an invaluable tool in the management of any portfolio.
Futures can be used to go short (i.e. to make money in a falling market) as well as going long (buying in an anticipation of a rising market).