Derivatives - explained

Derivative is very complex complex to explain but at its most it is financial contract between two or more parties and it derives its price from an underlying asset. Basically buyer agrees to purchase the asset on a specific date at a specific price. There are numerous types of derivatives and underlying assets can be almost anything but the most common are commodities (oil, gasoline, oil), currencies, stocks, bonds, interest rates and market indexes. They can be traded on unregulated over-the-counter market where transactions happen between private parties or they can be traded on exchange where they are highly regulated and standardized. Bear in mind that OTC constitutes major portion of derivative market and it caries great counterparty risk - possibility that one of the parties involved might default.

Common derivatives are options, futures,swaps and forwards. 

Options give the buyer right but not the obligation to sell or purchase underlying asset at a certain price on a certain date.

Futures contract is an agreement between two parties for purchase and delivery of an asset at a set price and future date.

Swap is an agreement between parities to exchange one asset or debt for a similar one to lower the risk.

Forward is an agreement between parties to buy or sell an asset at a specified price on a future date. That makes them similar to futures but forwards only trade on OTC.

As a leveraged instruments, derivatives have increased potential risk and rewards. When used correctly derivatives bring couple of advantages. They lock up prices and exchange rates and hedge against the risk. They can be leveraged which means derivatives only require small down-payment ("paying on the margin"). Derivatives give a lot of flexibility when it comes to investing strategy because they usually don't give the obligation to investor to exercise his or her right. Investor's portfolio can be diversified by adding certain percentage of derivatives but be careful. Derivatives are very complex type of securities and they are recommended to more experienced investors.

That brings us to potential pitfalls that derivatives carry with themselves. One of the reason is that is almost impossible to know their real value because it is based on one or more underlying assets. their complexity makes them difficult to price. Most of derivatives trade on the unregulated over-the counter market which makes them even more risky like their vulnerability to market sentiment, supply and demand, interest rates and costs of holding an asset among other factors. Time restriction is another major drawback. If derivative expires they become worthless and their lower liquidity compared to stock makes thing even worse. Because they are complex and not so easy to understand scam artist often use derivatives to take advantage of inexperienced investors.