There are three basic types of derivatives, forwards and futures, swaps, and options. Let's begin with forwards and futures. These financial instruments are both agreements to buy or sell an underlying asset at a future date. For a price determined date, there must be one side agreeing to buy and another side agreeing to sell the underlying asset for all futures and forwards contracts.

Let's imagine a trader who commits to purchase 10,000 barrels of oil. They enter into a trade which locks in a price of $76.50 per barrel, where they will take delivery of the oil in three months time. This is a classic example of a forward contract. Forwards and futures contracts are very similar, but there is one key difference between them. Futures are traded on exchanges providing the benefit of standardization and regulation while forwards are customized contracts traded over the counter between two counterparties directly tailored to the specific needs of the user.

Moving on to swaps, there's a huge variety of different types of swaps that can be traded, including interest rate swaps, credit default swaps, equity swaps, FX swaps, and others. Each type has its own unique mechanics, yet they all share one common feature. The exchange of cash flows over a period of time. Typically, these payments are exchanged at regular intervals annually, quarterly, or so on, and often one of these payments stream fluctuates based on some underlying assets performance. Let's have a look at a classic example of an interest rate swap. A fixed to floating interest rate swap. A trader agrees to pay a fixed 4% annual interest rate on 100 million dollars of notional principle receiving in return software, an interest rate, which resets on a daily basis on the same $100 million amount for a five year time period. The fixed payments are known upfront, the 4%, but the payments to be received will vary as SOFR changes over the next five years.

And finally, we've got options which are a distinct category of derivatives. Unlike forwards, futures and swaps under which both parties are required or obligated to fulfill, their side of the contract options offer more flexibility. They provide one of the two parties to the contract, the buyer of the option with the choice, but not the obligation to buy or sell an asset at a predetermined price known as the strike or exercise price on or before the contract's expiration. If you have an option to buy the underlying asset, it's referred to as a call option. If you have bought the option to sell the underlying asset, it's a different contract entirely referred to as a put option.

For example, let's imagine a trader who buys a three month call option on a stock at a strike price of 105. This means that they can buy the stock from the option seller for 105 in three months time regardless of the price of that stock in the open market. Let's imagine that the current stock price is 100 and if the stock price climbs to 107 before the option expiration, then the option owner would exercise or use their option buying the stock for 105 under the terms of the option contract, which is great because it's currently worth 107 in the open markets making for that trader an instant gain of 2. But if the stock falls down to 90, the trader can abandon their option, just not take up their rights, avoiding any loss they would've made had they bought the option under the terms of the contract for 105 when it was only worth 90. This flexibility makes options seem really appealing from the buyer's perspective. If things go in your favor, you make a gain. If they go against you, you don't have to suffer the loss. However, there is a cost to this, a premium that needs to be paid upfront to the seller. It's the non-refundable price for the right without the obligation to execute the trade that you are allowed to under the terms of the option. So while options carry clear benefits, they also come with their own cost consideration, which isn't there with forwards futures and swaps.