The name given to a contract between two parties which derives its value or price from an underlying asset or commodity such as gold or currency. Although the derivatives market may sound huge there are only three types of derivative – futures, options and swaps.
Futures are based on the forecast value of a commodity with no need to purchase while options give investors the choice to buy or sell and swaps enable them to change their exposure. Derivatives can be used in various ways and one of the most common is to hedge or reduce risk.
For example, if you have 100 1oz gold bars and you're worried that the price might fall but you don't want to sell and miss any possible profit you might sell a call option to reduce that risk. Derivatives can be used to arbitrage (take advantage of short-term price anomalies) and they can also be used for both hedging and speculation.