Here’s my brief and incomplete summary. When people think of market trading, they usually think of what are called “cash instruments”. You can buy a bushel of grain, for instance, or a share of stock in IBM, or a company bond, which means you’re loaning money to a company in exchange for repayment later. You can trade in your dollars for euros. All these are cash instruments. You can go to the market and find out exactly how much each of these things are worth, because you’re buying and selling actual assets.
In addition to these, though, there are financial instruments that aren’t directly based on assets, but are contracts whose value derives from the value of these assets, and there are called derivatives.
People categorize derivatives in different ways, but for purposes of this post, there are three kinds of derivatives; futures, options, and swaps.
Futures are contracts to buy or sell something at a future date for a price fixed in the contract. So, you could have a contract that says, “On March 1, Farmer Brown will sell to the other party in this contract 100 bushels of wheat at $6 per bushel” Then, when March 1 comes around, the other guy holding the contract gets his 100 bushels of wheat.
Options are like futures, except, instead of mandating that a transaction takes place at a certain date, they give the options holder the right to do it. A call option gives someone the right to buy a security at a certain date at a certain price, and a put option gives someone the right to sell a security at a certain date at a certain price. So, I might have a call option, expiring March 1, on 100 shares of IBM at $125. That means that on that date (or in America, on or before that date), I have the right to exercise my option and buy 100 shares of stock for $125 a share, no matter what the price is on the open market. If I don’t exercise my option by March 1, it goes away.
A swap is a contract to exchange parts of financial instruments by a certain date, but swaps give me a headache, and I’ve never really understood them, so I’ll let someone else explain them.