A derivative is a financial contract whose value comes from an underlying asset. You're trading a contract based on the price of something, like Bitcoin, gold, or the S&P 500, without owning the underlying asset itself. Derivatives let traders speculate on price movements, manage risk, and access markets with greater capital efficiency than buying assets directly.

How derivatives work

When you buy a stock, you own a piece of a company. When you trade a derivative, you own a contract that tracks the price of an asset. If you hold a Bitcoin perpetual contract, you don't own any Bitcoin. You own a position that profits or loses based on where Bitcoin's price goes.

This distinction might seem abstract, but it creates practical advantages. Derivatives let you go short (profit when prices fall), use leverage (control a larger position with less capital), and trade assets you might not be able to buy directly. You can express a view on crude oil, foreign currencies, or stock indices through derivatives without dealing with the logistics of owning those assets.

The main types of derivatives

Futures contracts are agreements to buy or sell an asset at a specific price on a specific future date. Traditional commodity and stock index futures have fixed expiration dates and standardized contract sizes. When the contract expires, it settles at the final price and your profit or loss is realized.

Perpetual contracts (perps) are futures without an expiration date. They're the most popular derivative instrument in crypto markets. Because they never expire, you can hold a perpetual position indefinitely, though you pay or receive a funding rate to keep the contract's price aligned with the underlying asset. Perpetual contracts are covered in detail in the next article.

Options give you the right (but not the obligation) to buy or sell an asset at a specific price before a specific date. Options are covered later in this category.

Why traders use derivatives

Speculation is the most common reason. If you think Bitcoin will rise from $60,000 to $70,000, you could buy Bitcoin directly. Or you could open a leveraged long position on a Bitcoin perpetual, which gives you greater exposure to the move with less capital. The tradeoff is that leverage amplifies losses just as much as gains.

Hedging protects existing positions. If you hold a portfolio of crypto assets and want to protect against a potential downturn, you can short a derivative contract to offset some or all of your downside risk. If the market drops, your derivative position profits, cushioning the loss on your spot holdings.

Capital efficiency matters for active traders. Derivatives let you control larger positions with less margin, which frees up capital for other opportunities. A trader who deposits $1,000 in margin to control a $10,000 position still has $9,000 available for other trades.

The risk that comes with leverage

Derivatives markets are where the largest and fastest losses happen. Leverage is a tool, and like any tool, it can cause damage when misused. A 10x leveraged position means a 10% adverse move wipes out your entire margin. A 5% move against a 20x position does the same.

Liquidation, where the exchange forcibly closes your position because your margin can no longer cover the loss, is the mechanism that enforces these limits. It happens automatically, without warning, and at the worst possible time. Understanding leverage and liquidation is essential before trading any derivative product, and both are covered in dedicated articles later in this category.