Explanation and overview: What are derivatives?

In the world of finance, a derivative is a financial instrument that allows you as an investor to speculate on the price performance of underlying assets such as shares, bonds or commodities, or to hedge against price risks. Derivatives such as warrants, futures and swaps offer investors various ways to invest. But how exactly do derivatives work in trading?

In this guide, we explain the meaning of derivatives, how they work and provide you with an overview of the different types of derivatives. You will also receive an explanation of how to trade derivatives and what risks and opportunities are involved.

Definition: Derivatives are financial instruments whose value is based on an underlying asset such as shares, commodities or bonds and whose price performance is determined by the price of this underlying asset.
Explanation: Derivatives function as contracts that regulate the future purchase or sale of an underlying asset under fixed conditions, enabling investors to speculate on price changes or hedge against future price fluctuations.
Types: Derivatives include certificates, futures, options, swaps and forwards, which are traded either on an exchange or over the counter.
Opportunities and risks: Depending on the underlying asset, derivatives are characterised by high volatility, particularly in over-the-counter trading, but at the same time they offer the opportunity to profit from market movements.

Simply explained: derivatives – what are they?

By definition, derivatives are financial instruments whose value depends on a so-called underlying asset. An underlying asset is the underlying investment on which the derivative is based, such as a share or a bond. A derivative itself is therefore not a physical product, but a contract that responds to the price movements of the underlying asset.

With derivatives, you can benefit from the price performance of an underlying asset without actually having to own it. In derivatives trading, investors can use this financial instrument to hedge themselves or speculate on future price movements.

What can you invest in with derivatives?

Investors can use derivatives to invest in various asset classes. In addition to securities, derivatives also offer the opportunity to invest in the market movements of physical goods or currencies. This gives investors access to numerous markets. Below are some of the most common asset classes in which derivatives can be used:

Shares: Investors can use derivatives to bet on the price performance of individual companies in order to benefit from the price movements of a single share.
Indices: With derivatives, investors can speculate on the performance of the DAX or the Dow Jones, for example, by betting on the price movements of an entire market or sector.
Commodities: Derivatives make it possible to bet on the price movements of commodities such as gold and silver without having to buy them physically.
Currencies: With derivatives, investors can trade currency pairs such as EUR/USD in order to benefit from exchange rate changes between different currencies.
Cryptocurrencies: Derivatives give you the opportunity to speculate on the price of cryptocurrencies such as Bitcoin, allowing you to take advantage of price fluctuations in this volatile market.
Bonds: Derivatives offer the opportunity to invest indirectly in government or corporate bonds by betting on the price performance or interest rate movements of these bonds.
ETFs: Derivatives can also be concluded on ETFs, enabling investors to bet on the performance of an entire portfolio of shares or bonds that is bundled within the ETF.

What types of derivatives are there?

Derivatives come in many different forms, each offering different characteristics and uses. Some of the best-known derivatives include options, futures, certificates, contracts for difference (CFDs) and swaps.

In the following sections, we will take a closer look at the individual types of derivatives, explain how they work and show how investors can use them in derivatives trading.

Options are standardised financial instruments that give the holder the right to buy an underlying asset at a fixed price and at a specific time (call option) or to sell it (put option). Such futures transactions can be traded on exchanges such as Eurex or the Chicago Mercantile Exchange (CME), where the exact option conditions are published clearly and transparently.
Important for you:
The special feature of options is that the buyer is not obliged to exercise their right. If the underlying asset develops unfavourably, the holder can let the option expire.
The counterparty – the so-called writer – is, however, obliged to deliver in the event of exercise (in the case of a call option) or to buy (in the case of a put option), for which they receive a premium.
In addition to classic options, there are also warrants, which work in a similar way to options:
Warrants are usually not standardised and are offered by banks or other issuers, meaning there is an issuer risk and repayment or payout may be at risk if the issuer becomes insolvent.
They grant the buyer the right to buy or sell an underlying asset at a fixed price within a certain period of time.
In contrast to options, which are often traded on exchanges, warrants are generally traded over the counter and can have different conditions and maturities.
Options and warrants offer investors the opportunity to speculate on future price movements of an underlying asset without actually owning it, making them a flexible strategy for derivatives trading.
Futures are binding forward contracts in which the buyer commits to buying or selling an underlying asset at a fixed price and at a specific point in the future. In contrast to options, where the buyer has only a right and no obligation, a future is a binding transaction. Futures can be traded on underlying assets such as commodities, shares or share indices. They are traded on futures exchanges such as Eurex or the CME, which makes them transparent and liquid. If the investor wishes to close their position before the specified date, they can sell the contract on. This process is known as “closing out”.
Forwards are also forward transactions, but they are less standardised and are not traded on exchanges. Instead, forwards are agreed over the counter between two parties. These contracts are tailor-made and offer greater flexibility, as they can be adapted to the specific needs of both parties. However, this flexibility also means that forwards are less regulated and involve higher risk. As with futures, forwards are binding contracts for the purchase or sale of an underlying asset at a fixed price and time.
Certificates are debt securities issued by banks or other issuers that give the holder the right to benefit from the value performance of an underlying asset. Unlike options or futures, certificates always involve an issuer, which entails issuer risk.
A special form of certificates are ETCs (exchange-traded commodities), which primarily facilitate trading in commodities. ETCs bundle futures contracts and offer the advantage that investors can invest in commodities without having to buy the physical goods themselves. Certificates can have different maturities, making them suitable for a wide range of investment objectives.
CFDs enable investors to speculate on the price movements of an underlying asset without actually having to own it. A CFD is a contract between the investor and a CFD broker in which the difference between the opening and closing price of the underlying asset is paid out. If, for example, an investor bets on a falling share price and the price falls after the contract is concluded, they receive the difference compared with the original price. CFDs are traded over the counter and cannot be traded with traditional online brokers, but only with specialised CFD brokers.
A key advantage of CFDs is the leverage effect, which makes it possible to achieve larger gains with a smaller investment. However, this also increases the risk of significant losses. CFDs are often used in day trading, but due to their high risk they are more suitable for experienced investors.
Swaps are financial instruments that enable the exchange of cash flows between two parties. Swap contracts are often used to hedge against interest rate risk or currency risk, but they can also be used to speculate on future price or value developments. The contractual terms of a swap are usually negotiated individually so that they meet the specific needs of the parties involved.
Examples of this type of derivative are
the interest rate swap, in which two parties agree to exchange fixed for variable interest rates
and the currency swap, in which payments in different currencies are exchanged.
Swaps make it possible to speculate on interest rate movements or currency developments and to benefit from positive or negative price changes.

Example: how do derivatives work?

After explaining what derivatives are, which asset classes you can trade them with and what types exist, we will now provide an illustrative explanation of how derivatives can be traded.

The price of derivatives depends directly on the underlying asset. Investors speculate on the price movements of an underlying asset, either betting on rising (long) or falling (short) prices. In this example, we explain how you can trade derivatives:

An investor believes that the share price of Apple will rise in the coming months and decides to buy a call option. This option is a conditional derivative that gives them the right to buy the share at a fixed price (strike price) within a certain maturity period.

Let us assume that the strike price is €250, the option has a maturity of three months and the option premium costs €15. If the price of the Apple share rises within the term, for example to €360, the investor can exercise the option. They buy the share at the strike price of €250 and could immediately sell it at the current market value of €360. The gross profit is therefore €110. After deducting the invested premium of €15, this results in an actual profit of €95 per share.

For the investor to break even, the share price must rise above the break-even point of €265 (€250 strike price + €15 premium). If the price of the Apple share is below €250 at the end of the term, the option expires worthless. In this case, the investor only loses the premium paid of €15. There is no obligation to buy the share at the (then higher) strike price.

This example illustrates that you can trade derivatives to speculate on the price movements of an underlying asset without owning it directly. The greatest advantage of derivatives lies in the ability to benefit from price movements with a relatively small capital investment, while the stake (the premium) is significantly lower compared with actually buying the underlying asset. However, derivatives trading also involves risks: if the underlying asset does not develop as expected, the investor can lose the entire premium.

Why are derivatives used?

Derivatives make it possible to speculate on price movements of underlying assets, hedge against risks, benefit from price differences between markets and expand investment opportunities. Here is an overview of what you can use a derivative for when investing your finances:

Speculation: Investors use derivatives to speculate on the price movements of underlying assets such as shares, commodities or currencies and to profit from future price changes.
Risk hedging (hedging): Derivatives offer a way to hedge risks (also known as hedging), for example by using futures, options or certificates to avoid price losses.
Arbitrage: You can invest in derivatives to benefit from price differences between different markets.
Expansion of investment opportunities: By trading derivatives, investors can access various asset classes and underlying assets that are often not as easy to trade with traditional investments, such as commodities or certain currency positions.

Derivatives offer a wide range of uses, expand investment opportunities and provide access to different markets and underlying assets. However, despite the many advantages, investors should be aware of the risks associated with derivatives trading.

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Opportunities and risks of derivatives

Derivatives offer numerous advantages, but also potential disadvantages that you as an investor should consider. An overview:

Opportunities of derivatives:

Leverage: Derivatives allow you to benefit from price movements with a low capital outlay, which can enable high returns.
Risk management: Derivatives offer the possibility to hedge portfolios against price losses or to profit from falling prices by deliberately speculating on declines.
Flexibility: Derivatives trading enables a wide range of investment strategies and access to markets such as commodities, currencies or indices, which are more difficult to reach with traditional investments.
Arbitrage: Derivatives can be used to exploit price differences between different markets in order to benefit from market inefficiencies.
Low capital outlay: Derivatives make it possible to benefit from price movements without buying the entire underlying asset, allowing a similar market position to be taken with less capital.
Access to international markets: Derivatives give investors the opportunity to invest in markets that are often not accessible through traditional investments, such as markets in emerging economies or specific commodity markets.

Risks of derivatives:

High loss potential: Due to leverage, losses can also occur that exceed the originally invested amount and, in the worst case, lead to a total loss.
Complexity: Trading derivatives is complex and requires in-depth understanding, as incorrect assessments can easily lead to significant financial disadvantages.
Volatility: Strong price fluctuations of the underlying asset directly affect the value of the derivative, which can increase volatility and lead to unpredictable losses.
Lack of transparency: Especially in over-the-counter transactions, transparency may be lacking, increasing the risk of engaging in opaque trading conditions.
Margin calls: With certain derivatives, it may be necessary to provide additional capital if the market moves against the position, further increasing the risks.
Market and counterparty risks: Derivatives trading is exposed not only to market fluctuations, but also to risks associated with the trading partner (counterparty risk), which can lead to financial losses.

Do you want to dive even deeper into the world of investing beyond derivatives? In the Bitpanda Academy, you will find many guides that help you better understand various financial instruments through technical analysis, manage securities trading in a targeted way or further develop your trading strategy.

FAQ

Frequently asked questions about derivatives

You now have a good overview of what a derivative is and how you can trade this financial instrument. In our FAQ, you will find further information and answers to frequently asked questions on this topic.

The term “derivative” describes a financial instrument whose value depends on an underlying asset. This underlying asset can be a share, a commodity, a currency, a share index or other financial products. Derivatives enable investors to speculate on the price movements of the underlying asset or hedge against risks without having to own the underlying asset itself. There are various types of derivatives, such as options, futures, certificates and swaps, which offer different trading strategies and purposes, for example speculating on interest rates and their future development.
The difference between shares and derivatives is that shares represent actual ownership stakes in a company, while derivatives are financial instruments that derive their value from an underlying asset, such as shares, commodities or interest rates.
When investing in shares, the investor actually acquires part of the company and thus, among other things, the right to dividends as well as participation in corporate decisions. Derivatives, on the other hand, do not grant ownership of the underlying asset, but merely the right to speculate on its future price movements or to hedge, without owning the underlying asset itself. While shares are considered long-term investments, derivatives are often used for short-term speculation or hedging strategies.
Yes, you can make money with derivatives, but it is also associated with significant risks. Derivatives trading makes it possible to profit from price movements of an underlying asset without owning it directly. Investors can generate profits by speculating on rising or falling prices of shares, commodities, currencies or interest rates. Especially through leverage, gains can be amplified, which also entails the risk of higher losses. Anyone who wants to make money successfully with derivatives should have sufficient knowledge and experience in derivatives trading and be aware of the risks.
Derivatives are taxable, with the exact tax treatment depending on the type of derivative and the frequency of trading. An overview:
Capital gains tax: Profits from derivatives are generally considered investment income and are subject to the flat-rate capital gains tax (25% plus solidarity surcharge and, if applicable, church tax).
Loss offsetting for futures transactions: Losses from futures transactions such as CFDs, futures, options or swaps can only be offset against other investment income up to a maximum of €20,000 per year.
Loss offsetting for other derivatives: By contrast, losses from other derivatives such as warrants or knock-out certificates can be offset against other gains without limitation.
Commercial income: Intensive trading in derivatives can be classified as a commercial activity. In this case, other tax regulations such as trade tax and higher income tax may apply.