It is important to note that every actively traded market discussed here is designed to do one thing and one thing only: operate as insurance for the cash market. The OTC market was developed as a way to customize the protection of commodities, currencies, and shares. Futures were developed to protect farmers against wild fluctuations in supply and demand, along with many other cash markets. Options evolved to protect shares and futures contracts. No matter what the underlying cash market is, whether commodities or equities, every derivative that has grown out of it was originally intended to manage risk or operate as a hedge.The fact that in order for any of them to work you need liquidity and speculators is the nature of the beast. Based on the level a speculator can afford, there are many places where he can interact, head to head, with the people who ultimately buy and sell the actual cash positions. If a trader has enough capital, he can operate directly in the cash market. However, the OTC market is the closest the majority of traders will come to trading the cash market. The futures market runs third in the daisy chain, and finally you have the options market.A multitude of different types of contracts are traded in each of these arenas, many of them so complex as to need a PhD in mathematics to understand them, let alone trade them. How these markets interact with one another is based on an amazing dance of credit, faith, history, technology, and rules—each one depending on the other to manage risk and diminish loss, while at the same time making the credit easier along the way so they can expand the number of market participants (speculators).CashWithout the cash market, none of the others would exist. Or at least the cash market would like to believe so. The majority of traders experience the cash market in only a few arenas—stocks, precious metals, and currencies. At one time or another on a small to moderate scale they may decide to get involved with any of the three markets out of necessity. Either they are participating in a retirement plan of some sort, or they visit a gold dealer, or they travel overseas. Whatever the case, they then experience the rules of the cash market firsthand.The cash market is straightforward. When you decide to purchase a share of stock for $1, you receive ownership of a share of stock for $1. The same can be said for investors who are familiar with spot transactions in gold and silver, whether they purchase a few precious metal coins or own several ounces of gold and silver bars. Investment in precious metals is an all-or-nothing deal. Investors who travel may have to exchange one currency for another. Rarely do individual investors purchase cattle, soybeans, or all the companies in an index.Those who have ever had a cash transaction have experienced one of the most frustrating experiences possible, the spread. Whether it is shares in a company, gold bars, or a foreign currency, the difference between the price you pay and the price at which the seller is willing to buy it back from you are often nowhere near each other. This spread, in addition to whatever other built-in markups there are, is how the cash market makers turn a profit.This is the danger zone. No one wants to lose their hard-earned capital. So in order to be able to speculate in the cash market but still have an out, the over-the-counter market was developed. Whatever position can be taken in the cash market can be offset or protected in the over-the-counter market for a fraction of the cost.Over-the-Counter (OTC)Currently the most popular OTC market in the world is foreign exchange (forex) trading. Trading upwards of $2 trillion a day (hard figures are difficult to come by since there is no central exchange), banks and retail investors rub shoulders in attempting to figure out what the true value of a country is. In the OTC forex market the rules are fairly simple. Two counterparties agree to cross buy and sell particular lots of foreign currencies that must be bought or sold back within a given time. This typically can occur anytime within a 24-hour period. If a position is carried overnight, then interest rate charges may accrue. Contracts for difference (CFDs) operate on the exact same principles as the OTC forex market.Just like the cash transactions, the difference between the bid and the ask provides a profit spread that the brokerage or bank uses to make its money. In return for the opportunity to earn your business, the brokerage or bank will extend you credit (i.e., margin) to buy and sell currencies throughout the day. While possible, rarely do retail investors choose to put up the face value of a currency contract. They will typically take advantage of the leverage provided in order to increase the returns on their dollars.For those companies or institutional investors actually holding on to cash positions in stocks or foreign currencies, the leverage of forex and CFDs gives them an inexpensive way to put on a countertrade just in case they have misinterpreted the market’s direction.FuturesThe futures market is the OTC market without the need for blind trust. Grown from the world of the OTC forward contract, the futures market provides several key services. The primary service is the centralizing of information. In the OTC market, every bank or brokerage offering contracts is able to set its own spreads and slightly different pricing. In order to get the best bid/ask spread or to discover the best pricing, a consumer (retail or institutional) had to call around. With the prevalence of the Internet, it is an easier task, but it still requires research on the part of the consumer to find the best deals.The by-product of the centralizing of information is the transparency in pricing and information. Anyone in the world can receive quotes from the exchange and receive the exact same price. Anyone can look at the Commitments of Traders reports and see exactly who is buying and selling what markets and the ebb and flow from the longs to the shorts and vice versa. Another key benefit of the exchanges is that there is no overt bid/ask spread. You have a likely chance to buy or sell at any quote on the screen if you are willing to put in a special order request, such as limits or stop limits.Finally, unlike the OTC market, you are able to hold on to your contracts for longer time frames, there are no interest rate charges for using margin or carrying contracts overnight, and your liquidity is not solely dependent on just the bank or the brokerage—you have the world.For those who hold significant cash or OTC positions, the ease of getting in and out of futures contracts and the ability to use margined contracts to do so are attractive prospects when you want to manage your risk.OptionsThe last instrument on this daisy chain is the option. There is a reason why the fee you pay for an option is called a premium and fee you pay for an insurance policy is called a premium. While the financial party line talks about options in terms of the “right” versus the “obligation” to own the underlying asset, the reality is quite simple. Options are an inexpensive insurance for the cash, OTC, and futures markets. Whether they are stock options, futures options, or currency options, they all operate with the exact same principles.For a small fee (a premium), you can purchase an option (put or call) at a specific price, typically the same price at which you got into one of your other positions, and for a set amount of time. The fact that you can purchase options in-, at-, or out-of-the-money is a testament to their ability to help you protect against risk.