Home / Course / Module 3 / What Are Derivatives?
Module 3 · Lesson 1 of 6A derivative is a financial contract whose value is derived from something else, such as the price of gold, a currency or an interest rate. This lesson gives you the map of the whole family before we look at each member in detail.
Risk warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Educational content only. Nothing here is a recommendation, and no result is guaranteed.
Most things you can buy in a market have a value of their own. A bar of gold, a share in a company and a pound sterling note are all underlying assets: the real thing, or a direct claim on it.
A derivative is different. It is a contract between two parties whose value depends on the price of an underlying asset (or a rate, or an index) rather than on anything the contract itself contains. The word "derived" says it all: the price of the contract is derived from the price of something else.
A simple everyday comparison is a bet on a football match. The ticket you hold has no value in itself. Its worth depends entirely on what happens in the match. A derivative is far more formal and regulated than a bet, but the idea that the value hangs on an outcome elsewhere is the same.
A derivative is an agreement about the price of something, not the something itself. You can gain or lose from a price move without ever owning the underlying asset.
The underlying can be almost anything with an observable price: a commodity such as gold or oil, a share, a stock index, a currency pair, a government bond yield, or even the weather in some specialised contracts. For this course, gold (XAUUSD) is our running example.
Derivatives were not invented to give traders something to gamble on. They grew out of a genuine need to manage uncertainty about future prices. Three kinds of participant use them.
A hedger uses a derivative to reduce a risk they already have. A hedge works like insurance: you accept a small, known cost to protect against a large, unknown loss.
A speculator has no underlying business exposure. They take a view on where a price is heading and use a derivative to act on it, accepting risk in the hope of reward. Most retail traders are speculators, and that is nothing to be ashamed of, as long as you understand that the risk is real.
An arbitrageur looks for small price differences between related markets, for example between a derivative and its underlying asset, and trades to profit from the gap. Their activity helps keep derivative prices in line with the underlying.
A small bakery will need 10 tonnes of wheat in three months. Wheat costs $200 per tonne today, so the bill would be 10 x $200 = $2,000. The baker worries the price will rise. They agree a contract today to buy 10 tonnes in three months at $205 per tonne, a total of 10 x $205 = $2,050.
The baker did not set out to win. They gave up some possible upside to remove uncertainty and plan their costs. That is hedging.
Derivatives are traded in two broad ways, and the difference affects cost, transparency and risk.
| Feature | Exchange-traded | Over-the-counter (OTC) |
|---|---|---|
| Where | A central exchange with public prices | Privately between two parties, usually via a dealer or broker |
| Contract terms | Standardised (fixed size, fixed expiry dates) | Can be customised |
| Who guarantees performance | A clearing house stands between buyer and seller | Each party relies on the other (counterparty risk) |
| Transparency | High: prices and volumes are published | Lower: prices are quoted by the dealer |
| Typical examples | Futures, many listed options | Forwards, swaps, retail CFDs |
A clearing house is an organisation that becomes the buyer to every seller and the seller to every buyer on an exchange. If one side fails, the clearing house, not the other trader, deals with the problem. In the OTC world there is no such middle layer, so you must trust whoever is on the other side of the contract.
That is why the quality and regulation of the firm you deal with matters so much in OTC products, a theme we return to in Derivatives: Risks and Regulation.
Almost every derivative you will meet belongs to one of four families. Each has its own lesson in this module.
A fifth item, the contract for difference (CFD), is not a separate family so much as a retail-friendly wrapper. It lets you speculate on the price change of an underlying asset through a broker. Because CFDs are what most UK retail traders of gold actually use, they get their own lesson: CFDs Explained.
Here is how the first four compare at a glance.
| Family | Obligation | Main use |
|---|---|---|
| Forward | Both sides must complete the deal | Locking a future price for a specific need |
| Future | Both sides must complete or close out | Hedging and speculating on an exchange |
| Option | Buyer has a choice, seller has the duty | Insurance-style protection and defined-risk bets |
| Swap | Both sides swap payments on schedule | Managing interest, currency or commodity exposure |
Two ideas appear again and again with derivatives. Learn them early.
Leverage means controlling a large exposure with a small amount of money. Many derivatives require only a fraction of the contract value as a deposit (called margin). That makes gains larger relative to your deposit, and it makes losses larger too.
Suppose a derivative gives you exposure worth $10,000 and requires a $500 deposit. The exposure is 10,000 / 500 = 20 times your deposit.
A move that looks small on a chart can erase the money you put up.
Counterparty risk is the chance that the other side of your contract fails to pay what it owes. On an exchange the clearing house reduces this. In OTC contracts it is a real consideration, which is one reason regulators supervise firms that deal with the public.
Leverage can lose money quickly, sometimes faster than you can react. Derivatives are tools, and tools can hurt people who have not learned to use them. Everything in this module is educational and is not a recommendation to trade.
If you trade gold through a broker, you are almost certainly dealing in a derivative, not owning metal. Understanding that fact helps you in practical ways.
For the basics of what XAUUSD is and how a gold CFD looks on your screen, see Gold Trading for Beginners. The next lesson, Forwards and Futures, starts with the oldest derivatives of all.
A derivative is a tool for transferring price risk from one party to another. Someone always takes the other side, and that someone may be better informed, better capitalised or simply a firm that profits from your trading costs.
No. A derivative gives exposure to the price without owning the metal, which is why the contract can be settled in cash. You do not receive bars, and you do not need a vault.
Professionals use them most, but retail versions such as CFDs exist. Retail versions are regulated because the risks are high, and many retail traders lose money, so education comes first.
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