Derivatives

A derivative is a contract whose value derives from another asset. There is an underlying — a stock, currency, interest rate or commodity — and the contract's profit or loss follows its price. Futures and options are the main examples.

The original purpose was transferring risk. A wheat farmer who fixes a price before harvest is protected from a collapse, and an airline that locks in fuel costs can forecast its expenses. This use is called hedging.

The difficulty is that the same instruments serve speculation. A small margin deposit controls a large position, so being right pays heavily while being wrong can cost more than you put in.

That structure is part of why derivatives amplified the 2008 crisis. For individual investors they are often complex with unclear maximum losses, so it is safer to stay away until you can state exactly what you are betting on. Note that derivatives are often embedded in products people already hold, such as structured notes and certain funds. A familiar name does not mean a simple structure, so read the product documents.