Derivatives are contracts whose value is linked to another asset or index. They can create leveraged exposure and losses can develop quickly. They are not a required component of a portfolio.
Futures
A futures contract creates an obligation under standardised exchange terms. Positions are marked to market and require margin. Adverse movements can lead to additional margin requirements or forced closure. A small initial margin does not cap the economic exposure.
Options
An option buyer pays a premium for a contractual right under specified strike and expiry terms. The buyer can lose the premium. An option writer receives the premium and takes the corresponding obligation; losses can be large and may not be limited to the premium received.
What changes a payoff
Direction and size of the underlying move, strike, expiry, volatility, contract multiplier, margin and transaction costs all affect the result.
A hedge can reduce one defined exposure while adding cost, basis risk, expiry risk and implementation risk. There is no universal hedge percentage. Named strategies such as covered calls or protective puts have different payoff limits and should be understood contract by contract.
Before using a derivative, read the exchange and broker risk disclosures, understand the maximum plausible loss and confirm that the position can be funded through adverse moves. This article explains mechanics only and is not a trading instruction.