By Sahil Bloom:

The term “derivatives” is often used in the world of finance. But for most people, it is just another example of complicated financial jargon. Often used, seldom understood. Let’s fix that. Here’s Derivatives 101!

A “derivative” is just a contract with a value that is based on something else. Its value is DERIVED from something else. If I create a contract called the SB that is linked to my # of Twitter followers, that is a derivative. The contract value is derived from my followers.

In financial terms, derivatives are a security that is tied to an another asset – called the “underlying asset.” The underlying asset could be: Stocks; Bonds; Commodities; Currencies; Interest Rates. Really anything can be an underlying asset. Get creative!

Derivatives can take on many different forms. The most common are: Options; Futures/Forwards; Swaps.

Derivatives are widely used by investors. The most common use cases are: Hedging – offset/protect a position; Speculation – bet on price moves; Leverage – amplify a position. Naturally, using derivatives for a hedge is less risky than using them for leverage.

This was a very basic, 10,000-foot overview on derivatives, their common forms, and their use cases. I will cover the common forms in additional detail (with simple examples, of course!) in future threads. So that’s Derivatives 101! I hope this was a helpful primer.