Don't get confused by a lot of clever stuff about how particular derivatives are (supposedly) traded. Understand the principles behind all derivatives and understand counterparty risk.
A derivative is a contract based on, or derived from, the performance of an underlying asset.
Here's one I made earlier
If you buy 100 shares in Unilever this gives you a right to future dividends, a share of the proceeds in a liquidation and a vote at General Meetings. These rights give that share a value - some function of the future dividend stream and/or capital proceeds on a liquidation or takeover. It is reflected in the price - currently (2020) £43 per share.
Now suppose I draw up a contract with you in which I promise to match the financial benefits of a holder of 100 Unilever shares. I'll pay you cash equal to the dividends and I'll pay you cash equal to any liquidation. That contract obviously has a value. You'd pay me something for it. In fact, as you have everything that a shareholder has except the vote you might pay me close to £43 for this contract.
This is called a derivative contract, or 'derivative' for short. It's nothing to do with Unilever, legally. They don't even know it exists. It's just a promise between you and me. It's only derived from Unilever's shares.
Let's make another
I could draw up another contract, in which I promise to match the financial benefits of one share in each of the top 100 UK companies. That is another, different, derivative.
Let's make betting complicated
Suppose I promise to pay you £10 if Hot Horse wins the 3.30 at Newmarket. If you judge Hot Horse is worth odds of 4:1 you'll pay me £2 for the promise. This promise is a derivative also (it's derived from the performance of Hot Horse). Of course real people would call this a bet.
So the first message is.....
There are an infinite number of possible derivatives. To talk about them generically (as in "we never use derivatives") is almost meaningless. New ones are being invented all the time. You need to understand the broader picture to be able to ask your adviser the right questions.
This sounds dead technical. Actually it's just like credit risk. And it's important.
Go back to the Unilever derivative offer to you explained above. I am your 'counterparty'. You rely on me to perform on my promise to pay you uncertain amounts over an infinite time horizon. But:
- You don't know if I'm honest.
- You don't know if the derivative contract (which may be quite complicated) does what it says it does.
- You don't know if I have the financial strength to perform on my promise.
- Even if I have the financial strength now, you don't know whether that will always be so.
This is called 'counterparty risk'.
The knock-on effect of a chain of counterparties being unable to honour their obligations (a domino effect) is called 'systemic risk'. Systemic risk is like the threat of a nuclear attack. We are right to worry but all we can do is hope the experts are doing something about it.
This is a big subject. Make sure your adviser understands it. You need to be rewarded for the risks you take.
The most popular derivatives have been standardised. There are two main groups - futures and options - covering a wide range of fundamentals including share prices, currencies, commodities and interest rates.
These are traded on specialised markets. The trader's counterparty is the market itself. He is dependent on the strength and reliability of the market's regulations and its ultimate backers.
To sum up
Derivatives are a brilliant tool of modern finance, totally fundamental to the management of financial risk. But this advice site is directed at the average man without a masters degree in finance. You do not have the competence to judge the real risks. You should in no circumstances personally use complicated derivatives as part of a long-term savings strategy. You should ask awkward questions about counterparty risk of any transaction where you give someone money in return for their promise to give you something else back. Er............ that's true of all investments isn't it?