Derivative is another term you may find talked about and perhaps misunderstood when people speak of financial markets. Derivatives have been blamed for the current world financial crisis, and it is true they were used to make the crisis, but the blame really lies with those who used them injudiciously. Just as guns do not kill anyone, people do, it is up to the user to proceed with care.
There’s really no secret to derivatives, they are just financial things that “derive” their values from other things. For instance, if you buy a share you are buying a genuine (very small) part of the company, so that is not a derivative. If you trade in futures or options, you’re trading in derivatives – the contract itself does not buy any goods or services, but simply commits to the future transaction – or in the case of options gives you the choice of a future transaction. Because it’s not a straightforward exchange of money for goods, derivatives allow you to leverage or gear the effectiveness of your money, as you pay less than the value of the goods they are based on. The prospect of increased profit is what makes them popular; increased losses make them dangerous.