What is a derivative
A derivative is a contract whose value comes from the price of something else, called the underlying, such as a currency, gold, an index, a share or an interest rate.
You do not own the underlying itself. You hold a contract whose value moves when the underlying's price moves.
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Worked example (hypothetical)
A trader and a counterparty, the other side of the deal, agree today to exchange a fixed quantity of gold at a fixed price on a set future date. This is a forward contract.
- If gold's market price ends above the agreed price on that date, the buyer gains and the seller loses the difference, multiplied by the contract size.
- If it ends below, the result is reversed.
- The settlement can be the gold itself or only the cash difference. See cash vs physical settlement.
Neither side paid the full value of the gold at the start. Many derivatives need only collateral or margin, so a small price move produces a large gain or loss relative to the money put in. Leveraged derivatives, including CFDs, can lose money fast.
Types of derivatives
| Type | What it is | Where it trades |
|---|---|---|
| Forward | Private agreement to buy or sell at a fixed price on a future date | Over the counter |
| Futures | Standardised forward with an expiry date | Exchange, cleared by a central counterparty |
| Option | Right, not obligation, to buy (call) or sell at a set price | Exchange or over the counter |
| Swap | Exchange of cash flows, such as fixed for floating interest | Mostly over the counter |
| CFD | Contract for difference: settles the price change in cash, no delivery | With a broker, over the counter |
Where you see the term
- Trading platforms. In MetaTrader 5 the symbol specification shows whether an instrument is a CFD or a futures contract, with its contract size and any expiry. Futures-based CFDs may show a roll.
- Company and bank reports. "Derivative financial instruments" appear with notional amounts (the size of the underlying covered) and fair values (the contract's current worth).
- News. Expiry days, open interest and reports of losses from hedging all refer to derivatives.
Formal definition and edge cases
Under international accounting standards (IFRS), a derivative has three features: its value changes with an underlying variable; it needs little or no initial net investment compared with buying the underlying; and it settles at a future date.
Edge cases:
- Embedded derivatives sit inside another contract, such as a convertible bond.
- Warrants and many ETNs behave like derivatives though they trade like securities.
- ADRs and GDRs represent shares held by a custodian; they are not derivatives.
- Rolling spot FX and CFDs have no fixed expiry but still derive their value from an underlying price.
Derivatives trading in Pakistan
On supervision, Securities and Exchange Commission of Pakistan (SECP), with trading in listed securities and commodities only via SECP-licensed securities and futures brokers. On licensing, under the Futures Market Act 2016, s.47(1), no one may carry on a regulated activity (futures broker, adviser, representative) without an SECP licence. On offshore products, per the SBP, the purchase of offshore forex/margin/CFD products by Pakistani residents violates section 4(1) of FERA 1947, and per the SECP, offshore platforms have no Pakistani licence or oversight and offer no legal protection or recourse. Read Regulation and Safety before using any platform.
Related terms
Counterparty, exposure, delta, contango, backwardation, front month, forward points. For the full list, see the trading glossary.
Frequent questions
What does derivative mean in simple words?
It is a contract whose price follows another asset's price, without you owning that asset.
Is a CFD a derivative?
Yes. A CFD settles the difference in the underlying's price in cash, so its value comes from that underlying.
What are the main types of derivatives?
Forwards, futures, options and swaps. CFDs are a broker-traded variant.
Why are derivatives risky?
Most use margin, so losses can exceed what a trader expects from the deposit size. See risk management.
Is a share a derivative?
No. A share is ownership in a company. An option on that share is a derivative.