- If you had a crystal ball that could tell the future, how could you use it to make money?

Well, you could buy stock in a company that you knew was gonna have a good year.

If you bought $10,000 worth of Nvidia stock one year ago, you would have around $23,000 today.

But that's only $13,000 in a year, and you had to have $10,000 to start with.

There must be a more efficient way to use this thing.

It's a magic ball, for crying out loud.

- [Philip] Apparently, a lot of investors felt the same way and wanted a more flexible, fluid way to bet on the future than just buying and selling stocks.

- [Julia] Enter derivatives, financial instruments that derive their value from some other underlying asset, like stocks or mortgages.

- Derivatives are considered advanced investing, and once we start explaining them, you'll see why.

Not only are they complex but also abstract in nature, which makes them hard to understand.

- Even with a crystal ball.

(bright music) - According to legend, the first derivative in recorded history was chronicled by Aristotle over 2,000 years ago.

He told the story of a philosopher named Thales who used his knowledge of the heavens to predict that the next season's olive crop would be bountiful.

There was no stock market in ancient Greece, so he couldn't buy shares in olive companies, but what he could do was pay a small fee to reserve all the olive presses in the area for next season's harvest time.

When the giant crop of olives eventually came in, Thales had the market cornered.

- Thales' strategy could be seen as the ancestor of the modern derivatives known as futures and options.

In simplest terms, a future is a contract between two parties to make a transaction at a certain price at a certain time in the future.

- Let's say lemons cost $2 a pound, but little Tina is worried that the price will go up, so she makes a deal with Sam the grocer to buy 100 pounds of lemons at $2 a pound one year from now.

That agreement is called a future.

If she's wrong and the price goes down, she'll be forced to buy the lemons at above-market price.

But if she's right and the price goes up, say to $3 a pound, Sam will be forced to sell her the lemons at below-market price.

Tina can now use the lemons to make lemonade or she can turn around and sell them for $3 a pound and pocket the $100 difference.

- In reality, most futures do not end up with a physical delivery of goods.

Rather than buy the lemons and sell them to Tina so she can resell them, Sam would just pay Tina the $100 in cash.

It's a much simpler way of settling up.

In fact, Tina probably wouldn't even be holding the future by then.

As soon as prices started to go up, she could sell it to a third party and realize the profits sooner.

That third party might sell it to someone else, who'd sell it to someone else, and so on and so on, with the value of the future fluctuating depending on the current price of lemons.

- If you think this sounds less like a transaction and more like two people betting on the price of lemons, well, you're not wrong.

Futures have become so theoretical that the underlying asset is often not an asset at all.

So-called event futures allow you to bet on all sorts of things, from extreme weather to politics.

You can buy a future on the amount of snowfall the Midwest will get this winter, or whether Congress will ban TikTok.

- Not everything is fair game, though.

The Policy Analysis Market was designed to allow people to buy futures on various political developments around the world, including movement of troops in and out of Middle Eastern countries, and political instability.

Supposedly, this would help the US government make informed decisions regarding defense policy.

But the idea led to fears that people would essentially be placing bets on terrorism in a terror market.

- Futures based on box office returns are also banned because movie studios worried their rivals could use the tool to sway public opinion.

And just recently, the Commodity Futures Trading Commission proposed a rule change that would forbid the trading of futures on the outcome of elections, fearing that gobs of Wall Street money might corrupt our democracy.

Can you imagine?

- Options are similar to futures, with two important distinctions.

First, options typically only apply to stocks, not lemons or snowfall or presidential elections.

Second, options give the buyer the right to buy or sell a stock at a certain price in the future, called the strike price.

But it's not an obligation.

If the holder of an option doesn't like how the stock price has changed, they can choose not to exercise it.

Obviously, this puts all the risk onto the vendor of the option, so the buyer must put some skin in the game in the form of a premium, which they don't get back whether or not they exercise the option.

- Edgar here just heard that his favorite fast food chain, Patty's, is planning to introduce a new plant-based burger.

He's sure it will be a disaster, so he decides to buy an option to sell, known as a put option, 100 shares of Patty's stock at a strike price of $20 per share in three months time.

At $2 per share, the premium will cost him $200.

The plan is that once Patty's stock price falls, he'll be able to scoop up 100 shares for cheap and then sell them at $20 per share for a nice little profit.

- Unfortunately, for Edgar, the plant-based burgers are a hit and Patty's share price rises to $25 by end of the term.

Edgar's option is essentially worthless.

He chooses not to execute and eats the $200 premium as a loss.

On the bright side, if it had been a future instead of an option, he would've been forced to sell 100 shares of Patty's stock for $20, which would've cost him $500 instead of 200.

- Traditionally, options and futures were used as a hedge, a way to reduce the risk of loss in a volatile market.

If a farmer is worried about a potential drought that could ruin his crops, he can buy a weather future that will pay out if this happens, minimizing the damage.

However, they're increasingly being used as a speculative tool, a way to increase one's risk and potential reward.

For instance, you could buy stock in an up-and-coming company and then buy a call option on the stock so that, if the price goes up like you hope, you'll hit the jackpot.

- There are also claims that futures and options help make the market more efficient.

Having all these big brains gambling on the price of lemons supposedly gives us a more accurate idea of what lemons are actually worth.

And allowing money to flow more freely allows the market to react more dynamically to changing conditions.

- But derivatives remain extremely perilous for individual investors.

Not only are they much more complex than other financial instruments, they also allow you to take on a large amount of risk with a relatively small deposit.

- Many economists consider them just a form of gambling, and Warren Buffett famously called them "financial weapons of mass destruction."

- Even if you're experienced enough to understand what you're getting into, there's also the small problem of predicting the future.

- Which humans have never been very good at.