What is a derivative?

The value comes from something else

A share is a part of a company. A derivative owns nothing like that. It is a contract whose value follows something else, the underlying. The common kinds:

• Options: the right to buy or sell at a set price.
• Futures: a binding agreement to buy or sell at a set price on a set day.
• Warrants: options and knock-outs issued by a company or a bank and traded like stocks.
• Swaps: agreements between two parties to exchange payments, such as a fixed interest rate for a floating one, mostly between banks and companies and never traded on an exchange.

A leveraged ETF is a fund rather than a derivative, but it uses derivatives to reach its daily target.

One day, six positions

On Mar 16, 2020 the S&P 500 fell −12.0%, its worst day since Jan 3, 2000. How that same day would have hit different positions:

The same move gives very different results. The −2x ETF and the short sale gained from the fall. The knock-out with its stop 10% below the price ended that day, and the whole stake was gone. The future lost −$16,245 on one contract, although its buyer had only put up a deposit.

Protection or risk

The same derivative can reduce a risk or add one. An owner of shares who buys a put has protected against a fall. Someone who buys the same put without the shares is taking a pure risk. What decides how much can be lost is in the lesson on leverage.