A derivative is a financial instrument that derives or gets it value from some real good or stock. It is in its most basic form simply a 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.

Derivatives made the news in 1995 when rogue trader Nick Leeson single-handedly caused the failure of the Barings bank of England. Nick Leeson was a derivatives trader whose trades did not work out, and due to the enormous leverage of the trades used, the losses became so large that the bank was bankrupt when the results of his trades become due. Warren Buffet, a much revered and very successful investor, has stated in one of his annual reports that he is very much against the use of derivatives and he expects that they will lead to eventual failure for anyone who uses them. In spite of all this negative press, derivatives have long been a normal part of business and investing and are likely to be so for many more years.