Making sense of derivatives.

A value that derives from something else

The word "derivatives" frightens people, but the idea is simple. A derivative product is an instrument whose value derives from that of another thing, called the underlying.

Imagine making an agreement on the future price of a crate of apples, without buying the apples. You do not own the goods: you own a contract linked to their price. That is a derivative.

The underlying: where the value comes from

The underlying can be almost anything: a share, a stock index, a currency, a commodity, even an interest rate.

The derivative moves according to how its underlying moves. This is why derivatives exist on everything: they let you take a position, or protect yourself, on an asset without actually having to own it.

The main types

The most common derivatives are few.

• Futures: an agreement to buy or sell at a set price and on a set date.
• Options: the right, not the obligation, to buy or sell. We explain them in full in the guide how options work.
• Structured products: products that combine several instruments in a single package.

What they are really for

They were born for a very concrete reason: managing risk.

A farming business can fix the price of its harvest today, so as not to suffer future falls. An investor can protect the value of a portfolio from a decline. They are, first of all, instruments of protection. Then, of course, they can also be used to take a position.

Why they are frightening (and when that is justified)

The bad reputation of derivatives comes from a use that is wrong: excessive leverage, complexity that is not understood, bets made without rules.

But the instrument in itself is neither good nor bad. A knife cuts bread or does harm: it depends on who uses it, and how. With clear rules, derivatives become instruments of management, not of gambling.

“Derivatives are not the problem. Using them without knowing what you are doing is.”

How the Plutonis System uses them

The Sistema Plutonis uses one precise type of derivative, options, and it does so in a way that is non-directional: it sells them, collects the premiums and defines the risk before every trade.

It is not gambling: it is the disciplined use of an instrument that professionals have been using for decades.

In summary

A derivative is just an instrument whose value derives from something else. It serves to manage risk, and it becomes dangerous only when it is used without rules.

To see how they are used with method, start with the guide How the Plutonis System works.

Stefano Lokar Pignatari

Creator of the Plutonis System · former portfolio manager, over 1 billion managed in the institutional world. His story →