A financial derivative is an instrument that gets value from a good stock. In a nutshell, it’s the most basic contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.
The largest appeal of derivatives is that they offer some degree of leverage. Leverage is a financial term that refers to the multiplication that happens when a small amount of money is used to control an item of much larger value. A mortgage is the most common form of leverage.
For a small amount of money and taking on the obligation of a mortgage, a person gains control of a property of much larger value than the small amount of money that has exchanged hands.
Derivatives offer the same sort of leverage or multiplication as a mortgage. For a small amount of money, the investor can control a much larger value of company stock then would be possible without use of derivatives. This can work both ways, though.
If the investor purchasing the derivative is correct, then more money can be made than if the investment had been made directly into the company itself. However, if the investor is wrong, the losses are multiplied instead.
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