The derivatives market is a financial market where contracts are traded instead of the underlying assets themselves. The value of these contracts is derived from the price of another asset.
This is why it is called the derivatives market—because the value of each contract is derived from the value of an underlying asset.
The underlying asset can be a stock, commodity, currency, financial index, interest rate, cryptocurrency, or many other types of financial assets.
Why Was the Derivatives Market Created? #
The primary purpose of the derivatives market was to help individuals and businesses manage risk.
For example, a farmer may be concerned that the price of a crop will fall before harvest, while a manufacturer may worry that the cost of raw materials will increase. The derivatives market allows both parties to enter into contracts that help reduce these risks.
Over time, derivatives markets evolved beyond risk management and became important tools for investing, trading, and speculation. Today, they account for a significant portion of trading activity across global financial markets.
What Is Traded in the Derivatives Market? #
Unlike the spot market, the actual asset is generally not bought or sold in the derivatives market.
Instead, traders buy and sell contracts whose value depends on the price of an underlying asset.
As a result, many participants in derivatives markets never become the actual owners of the underlying asset. Instead, they earn profits or incur losses based solely on changes in its price.
What Is an Underlying Asset? #
An underlying asset is the asset whose value determines the price of a derivative contract.
For example, if a derivative contract is based on gold, its value will move according to the price of gold. Likewise, if the contract is based on Bitcoin, its value will change as the price of Bitcoin changes.
Derivative contracts can therefore be created using stocks, currencies, commodities, stock market indices, interest rates, cryptocurrencies, and many other financial assets as their underlying assets.
The Main Types of Derivatives #
The derivatives market includes a wide variety of financial instruments, but the two most common types are:
- Futures contracts
- Options contracts
In recent years, another type of derivative known as perpetual contracts has become especially popular in cryptocurrency markets. These contracts are structurally similar to futures contracts but do not have an expiration date.
In the following lessons, we will explore each of these instruments in greater detail.
Features and Advantages of the Derivatives Market #
The derivatives market offers several features that are generally not available in the spot market. These include risk management, the use of financial leverage, the ability to profit from both rising and falling prices, and access to a wide range of trading instruments.
However, these same features also make derivatives trading more complex and generally riskier than spot trading. For this reason, it is important to understand how the derivatives market works before trading in it.
Summary #
The derivatives market is a financial market where contracts are traded instead of the underlying assets themselves. Although it was originally created as a tool for managing risk, it has evolved into one of the world’s most important markets for trading and investing.
One-Sentence #
In the derivatives market, contracts are traded instead of the actual assets, and their value is derived from the price of an underlying asset.