In finance, derivatives are a kind of instrument based on the value of other underlying instruments, like stocks, bonds and real estate; some derivatives are even based on non-financial variables, like the weather. Each derivative itself is a contract between two parties that formalizes their agreement to exchange assets after a certain set of conditions has been met (e.g., a stock market index reached a certain benchmark).

Hedge fund managers and other professional investors often use derivatives like options and especially futures to lower the risk of their primary investments. Although there is a certain mystique surrounding derivatives, due in part to their flexible and ambiguous nature, smaller businesses and individual investors can benefit from including them in their portfolios and investment strategies. Here are some important key facts about derivative instruments to remember before jumping in and investing.

1. Derivatives instruments can be divided into two major groups: over-the-counter derivatives and exchange-traded derivatives.

2. The most common derivatives are futures contracts, forward contracts, options and swaps.

3. Derivative instruments are traded on derivatives exchanges that operate much like stock exchanges.

Action Steps
The best contacts and resources to help you get it done

Research derivative instruments before you invest

As with traditional instruments like stocks and bonds, investing wisely with securities requires you to know their basic features before making a financial commitment. It's a good idea to familiarize yourself with each of the major derivative instruments, that way you can make the best use of your business' money when a financial problem or investment opportunity arises.

I recommend: The International Swaps and Derivatives Association maintains a extremely detailed glossary and FAQ. You can also learn about accounting for derivative instruments and hedging activities by consulting the Financial Accounting Standards Board website.

Use over-the-counter derivatives to make deals with other organizations

Over-the-counter derivatives, also known as privately-negotiated derivatives, allow you to sign contracts with individual financiers and organizations without the help of a derivatives exchange. Swaps, exotic options and forward rate agreements are some of the most common OTC derivatives. Credit swaps in particular are used by businesses who need to restructure their loans without the bank's assistance.

I recommend: Learn the basics of credit default swaps from Investopedia. These can be used as a kind of insurance policy against negative credit events like defaults and credit rating downgrades. The Federal Reserve Board can also assist with information about the OTC credit derivatives market.

Trade derivative financial instruments on derivatives exchanges

Derivative trading is very similar to stock trading and you can do it through a variety of domestic and international exchanges. Futures and options are the two derivatives you'll have the easiest time trading over the exchanges.

I recommend: Three of the biggest domestic derivative exchanges are the New York Mercantile Exchange (NYMEX), Chicago Board Options Exchange and Chicago Mercantile Exchange. The NYMEX trades an especially wide variety of products, offering derivatives based on currency, weather, commodities and energy.

Tips & Tactics

Helpful advice for making the most of this Guide

• •  Make a habit of reading derivative instruments financials whitepaper reports. They propose solutions to major issues in derivatives markets and accounting for derivative financial instruments.