Derivatives and derivative markets were initially created to remove seasonal price fluctuation, but in contemporary finance, derivatives have the following functions.

Risk allocation, transfer, and management

Derivatives facilitate investors who want to reduce/increase the level of risk in their portfolios without selling/buying the underlying.

Information discovery

The price and volume of information obtained from derivative markets have some predictive power about expected spot market prices. Most importantly, they allow investors to price risk; and calculate implied volatility (in case of options).

Operational advantages

These advantages include lower transaction costs (with reference to the value of underlying), higher liquidity, and ability to take short positions easily.

Market efficiency

Lower transaction costs, fewer capital requirements, etc. makes it easier to exploit any mispricing and increase efficiency.

Criticism and misuse of derivatives

The main arguments against derivatives are that they allow investors to obtain unsustainable positions that elevate systematic risk so much that they can be equated to legalized gambling.

Speculation and gambling

Derivative markets functions when speculators buy risks from hedgers, speculators typically have such a short-term horizon that their trading hurts the market efficiency in the long run. This is why some people label derivatives as legalized gambling.

Destabilization and systematic risk

Lower transaction costs and lower capital requirements may encourage speculators to enter into highly-leveraged positions which are too risky and any advance movement may cause financial distress not only for the speculator but for its creditors and this can spread to the whole financial system (and economy) through the process of contagion.

Complexity

Some investors criticize derivatives for being too complex and based on models that are far from reality.


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