How do derivatives work?

Derivatives are financial instruments whose value is derived from an underlying asset or group of assets. This underlying asset can be a commodity, a currency, a stock, a bond, or even another derivative.

Derivatives work by allowing investors to speculate on the future price movement of an underlying asset without actually owning the asset itself. Instead, investors buy or sell contracts that represent the underlying asset, such as futures, options, or swaps. The value of these contracts is directly linked to the value of the underlying asset, and their prices are determined by supply and demand in the market.

For example, a futures contract is an agreement to buy or sell an underlying asset at a predetermined price and date in the future. If an investor believes the price of the asset will go up in the future, they can buy a futures contract to lock in the price and profit from the price increase when the contract is settled. Conversely, if an investor believes the price of the asset will go down, they can sell a futures contract to profit from the price decrease.

Derivatives are used for various purposes, such as hedging, speculation, and arbitrage. However, due to their complex nature and potential for high leverage, they can also be risky and should only be traded by experienced investors who understand the risks involved.