Derivative security

A derivative security is a financial contract that does not have value on its own. Instead, its price is based on, and moves because of, something else — a stock, a bond, a commodity like oil or gold, a currency pair, an interest rate, or even an index like the S&P 500. That "something else" is called the underlying.

The basic idea is that instead of buying or selling the underlying asset directly, you buy or sell a contract that references its price. Common types include options, which give you the right (but not the obligation) to buy or sell the underlying at a set price by a certain date; futures, which obligate two parties to transact at a set price on a future date; and swaps, which exchange one stream of payments for another. Each of these derives its price from moves in the underlying, but usually amplified, delayed, or reshaped by the contract's own terms — strike price, expiration date, contract size, and so on.

The nuance that trips beginners up is that a derivative's price does not move one-for-one with the underlying. An option on a stock can gain or lose value even if the stock barely moves, because of factors like time decay (the contract loses value as expiration approaches) or changes in implied volatility (the market's expectation of future price swings). So "derivative" describes the source of value, not the size or timing of the move.

Another point of confusion is that derivatives can be used very differently by different people. Some use them to speculate with leverage, controlling a large notional exposure with a small amount of capital. Others use them to hedge, offsetting risk they already have elsewhere. The contract is the same; the purpose is not.