Derivatives

Once upon a time, people just used to buy houses or shares in companies i.e. they were dealing with the real world. However, to reduce risk financial services companies started to create more exotic types of transactions called derivatives which are derived from the base financial instruments.

An example of a derivative is a futures contract. This is an agreement whereby the purchaser agrees to buy stock (a share in a company) at a future date. This is often used to purchase bonds which pay an income during the holding period in the full knowledge that you have a guaranteed selling price and can therefore calculate it's yield.

Trading on margin via contracts for differences (CFDs) is another example of a derivative. Here you can go long (make money if price goes up) or short (make money if price goes down) on a stock. If the price moves in the opposite direction to that which you expected e.g. you bought stock long at £1 with a leverage of 10:1 i.e. you only put 10p down and the stock price went down to 90p, then you'd lose your entire stake. The leveraged aspect of contract for differences magnifies your gains and your losses. Traders often use CFDs for hedging e.g. they go long at 10:1 and short at 9:1 on the same or related stocks, thereby being able to play with more money than they've personally got but also reducing their exposure.